Too Tight?
November 6, 2022 – Weekly Comment
“Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”
–Jerome Powell, October 3, 2018
On Sept 26, 2018, with inflation remaining near 2%, the Fed hiked ¼ to 2.0-2.25%. Powell’s comment above was right after that meeting. At the November meeting rates were kept steady. December 19, 2018 was the final hike, to 2.25-2.5%, but the wheels had already come off, from Oct 3 to Dec 19, SPX fell over 15%, and by Dec 24 it was down 19.5% (in less than three months).
Powell at last week’s press conference, “…very premature to be thinking about pausing” and “it’s tough to make the case that the Fed is too tight.” In late 2018 the market had concluded the Fed WAS too tight. By the end of the year, every option trade in the short end was focused on ease trades. Besides the equity market, what were other clues of Fed stinginess? 1) the red/green Eurodollar pack spread (2nd to 3rd year) was over 20 bps early in 2018, but ended the year at -8, sinking to an eventual low inversion of -9.6 in March 2019. 2) the 2/10 treasury spread was 78 bps in early 2018, and ended at 10.7, eventually inverting to -5 bps by August 2019. Inverted curves reflect a tight Fed.
Is it hard to make the case the Fed is too tight now?
Currently the red/green euro$ pack spread is -58.25, having hit a historic low of -62 on Thursday, more deeply inverted than 2018 by over 50 bps. Red/green was positive 30 bps in January. On Friday, 2/10 ended -49.6 bps, having reached a new low of -57.3 on Thursday, just taking out a previous low of -56 from the year 2000. It started the year +90. A decline of nearly 150 bps in 11 months.
However, in 2018 the high of yoy Core PCE was only 2.1%. The terminal FF target actually exceeded this inflation measure. The high so far this year in yoy Core PCE is 5.4%, the current EFFR is 3.83% and the peak FF target as forecast by the FF futures curve is 5.085%, as both FFM’23 and FFN’23 settled 9491.5. So perhaps by this metric, the Fed is NOT too tight. The question is whether Core PCE prices will begin to retreat below 5% and eventually sink below the FF target. This is the dragon that Powell wants to slay.
On this score, it’s worth noting that the Fed’s balance sheet has declined by a few percent since the peak in April, and that it’s now below where it started 2022 (current $8.677T vs $8.757T at the end of last year). More importantly, consider yoy M2 and Core PCE prices on the chart below. YOY M2 growth has plummeted to just 2.6%, having screamed as high as +25% in response to covid. For the sake of comparison, during the GFC, M2 growth reached just over 10%, followed by a rebound in inflation from the lowest level since the turn of the century at +0.6% to a peak of 1.8% in 2010. Correlation is not causation, but it certainly appears as if inflation followed the surge in M2. Might the recent plunge in M2 foreshadow a sharp deceleration in prices? If so, then it wouldn’t be surprising for Core PCE prices to decline below EFFR some time in 2023. It’s also likely that the elections will solidify perceptions of gridlock with respect to government spending, thus restraining a growth catalyst.
When looking at some of the week-to-week changes, near one-year calendar spreads exploded higher: for example SFRZ2/Z3 went from -12.5 to +16.5, and FFF3/FFF4 from +6.5 to +39.5, changes of 29 bps and 33 bps respectively. The market has accepted the idea that eases may be pushed later into 2023 or even into 2024. However, consider just the settle of FFF3. This contract now prices the December FOMC. After last week’s hike, EFFR is 383 bps or 9517.0 in terms of price. FFF3 settled 9560, or 57 bps higher than the current EFFR, up from the previous Friday settle of 9558. In other words, the market is leaning toward 50 at the last meeting of the year, rather than another 75. For now, the market has embraced Powell’s messaging: smaller rate increases which may continue for a while.
The two-year note is the only maturity that made a new high for the move, ending the week at 4.65%. The 30 yr bond ended just below 4.25%; October’s high was 4.38%. Auctions of 3s, 10s and 30s this week. CPI is Thursday, yoy expected 7.9% vs 8.2% last. Core expected 6.5% vs 6.6% last; note that the Core 6.6% reading last time has been the high of the cycle. Veteran’s Day is Friday. Banks and the Fed will be closed.
Election day is Tuesday. (Results in a few weeks).
“Good, better, best. Never let it rest. ‘Til your good is better and your better is best.” -St Jerome.
It’s a good bet that anyone who names their kid Jerome is knowingly heaping that weight onto their shoulders…
2/10 treasury spread (while) red/green ED spread (green)
OTHER MARKET THOUGHTS/ TRADES
During the press conference, with respect to housing, Powell mentioned that the difference now is that credit underwriting this time around was a lot more stringent. Certainly, that may have been the case for housing, but many other capital allocations were lax and misguided. As tweeted by @ArifHozef: “Everything is an extension trade now. Previously “yield to call” bonds now trading to maturity. Home flippers forced to pivot to land-lording. Everything is ageing in place.”
A company called Opendoor (OPEN) reported last week a net loss of $928 million in Q3, more than 17 times what it lost in Q2. As one article noted, “Opendoor has become the poster child for a housing market slowdown.” This is a company that buys and sells homes. A flipper. It closed Friday -13% at 2.02, having been over 24 a year ago. Carvana (CVNA) has the same model with cars. It fell 39% Friday to 8.76, having been over 300 one year ago.
Sam Zell last week warned of a possible ‘liquidity crisis’. Before covid consumed everything, the Fed spent a lot of time analyzing the repo rate surge of September 2019. On 9/17/19, with the FF target 2.00-2.25% and SOFR around 2.2%, the overnight repo rate rocketed to 10% forcing emergency measures to get it back under control. Treasury last week revised the Q4 borrowing schedule to $550 billion from $400b. Japan’s holdings of US long-term treasuries have declined by $100 billion so far this year as it maintains the 25 bp JGB cap. Implied vol declined hard in the wake of the FOMC meeting and employment report, but risks remain.
STRADDLE DECLINES: On Nov 1: contracts and settles.
EDH2 9468.75^ 47.75, EDH4 9537.5^ 138.25, 0EH 9537.5^ 77.5, 2EH 9600^ 77.5 and TYF 111^ 3’04.
By Friday Nov 4:
EDH3 9468.75^ 42.25, EDH4 9525.0^ 129.0, 0EH 9525.0^ 71.5, 2EH 9587.5^ 71.5 and TYF 110.5^ 2’42.
| 10/28/2022 | 11/4/2022 | chg | ||
| UST 2Y | 442.0 | 464.6 | 22.6 | |
| UST 5Y | 419.0 | 432.0 | 13.0 | |
| UST 10Y | 400.8 | 415.0 | 14.2 | |
| UST 30Y | 413.0 | 424.3 | 11.3 | |
| GERM 2Y | 193.9 | 212.8 | 18.9 | |
| GERM 10Y | 210.3 | 229.5 | 19.2 | |
| JPN 30Y | 146.0 | 155.5 | 9.5 | |
| CHINA 10Y | 267.5 | 270.6 | 3.1 | |
| SOFR Z2/Z3 | -12.5 | 16.5 | 29.0 | |
| SOFR Z3/Z4 | -67.0 | -78.0 | -11.0 | |
| SOFR Z4/Z5 | -17.5 | -28.5 | -11.0 | |
| EUR | 99.65 | 99.84 | 0.19 | |
| CRUDE (CLZ2) | 87.90 | 92.61 | 4.71 | |
| SPX | 3901.06 | 3770.55 | -130.51 | -3.3% |
| VIX | 25.75 | 24.55 | -1.20 | |
https://therealdeal.com/2022/11/03/opendoor-posts-1b-loss-as-market-slowed-faster-than-expected/
