160501 ED5 vs ED1The first year fly (EDH6-H7-H8) is now -11.  This seems a little strange with the locally-high ED5 1 year fly being +5.  It turs out we are at the cusp of three different regimes.  And while the markets seem to think we could sit here, I think we will make a break in the next month or two.  The scatter plot on the right shows 5 years of ED5 and ED1 one year flies.  The black dot is the close on Friday.  The mass on the upper right is from the past year (where hikes were mostly priced in in the near-term), the mass on the upper left is from two years ago (when there were no near-term hikes but hikes were priced into the horizon), and the mass on the bottom is from the 3-5 years ago (where there didn’t look to be any hikes any time soon).  So which path are we headed towards?[1]

The path that makes the least sense to me is the one that goes to the upper left.  I’m not saying we couldn’t be on hold for a short while and hike again.  But if oil, China, junk bonds, commodities, EM, etc. really are such a big problem, what exactly is going to get fixed this year?  I would say nothing.  And considering most of the leading Presidential candidates seem to be on a similar level of ineptitude as the current administration, I’m not expecting anything magical to happen in 2017 and beyond.  So any path that realizes the downside in growth and inflation is going to take the entire front of the curve with it (lower left).  The degree to which we can move left is limited by the flatness of the curve.  But we may move more than expected if the Fed has to ease, or go to negative rates.

However, I’m not really a gloom and doomer… I have been talking about the downside pressures on growth and inflation for a while, whether its demographics, or disintermediation, or globalization, etc.  All things considered, we are actually doing “better than I would have thought.”  I was calling for a skip at the Sept 2015 meeting, way before many other analysts.  So it’s not as if I don’t see downside risks on global market shakiness.  But clearly what I am envisioning now, and what is being priced into the markets are completely different mean scenarios.  So from time to time, we need to take a step back and reassess.

WSJ warnings mountThe big hurdle for me right now is that we have seen very little in the data.  Yes, Q4 GDP was weak, and manufacturing is weak.  I’m not sure GDP is necessarily a trend, but manufacturing will keep being small.  The WSJ graphic on the right shows that things aren’t really that horrible right now.  And it has been my assertion that we probably overshot on some metrics because of Fed accommodation, so a correction is understandable.  I think this is how the Fed is probably thinking right now, and they are the folks who set the rates.

We get payrolls next week.  The expectation is for 188K on the headline payrolls.  The pre-holiday numbers seemed high, so it is reasonable to assume the post-holiday correction/layoffs would he high as well.  The UR expectations are for 5.0%, with the range being 4.9% to 5.0%.  This is why the data is a little perplexing… there is a chance we could print 4.9% (the Fed’s “neutral rate”).  And there is less than 1 hike priced in for 2016?  This to me does not compute.  We get PCE on Monday.  Headline and core PCE inflation are expected to print 0.0% and 0.1% respectively.  But the yoy print should be a few tenths higher on the headline.

I realize the data are backward-looking.  And lower oil, China, EM, commodities, are all going to put downside risk on inflation going forward.  But my central forecast for these things weren’t for them to be noticeably stronger in 2016.  The Fed sees 1.6% and 1.6% on headline and core respectively.  That’s probably high, but I’m not sure we couldn’t get there by year-end.

So the two most important pieces of data to the Fed seem to be somewhat stable.  Yes – there are downside risks to growth and inflation.  But the over/under on the amount of hikes in 2016 being 20bps seems aggressive.  And factor in this… that if you looked at the markets right now and oil was $40, or the S&P was at 2000, wouldn’t things look much different?  It doesn’t take a whole lot for that to happen – in fact, those things can happen on absolutely nothing!  And we could get a nudge with the early Feb data.

This leads me to my next point, which is to look at the markets from a conditional probability perspective.  IF the 20bp over/under is correct, what does that mean?  I would say that collapse is imminent, and that the Fed could ease later this year.  This is because there’s always the chance the Fed could hike 3+x times this year, so for the mean to be 20bps, people have to be awfully certain the Fed does nothing for there to be no ease priced in.

If things are so bad the Fed does nothing, why couldn’t things be so bad the Fed eases?  One client bought EDJ6 99.50 calls a few days ago at 0.5.  Clearly eases are not priced in to any great extent in the markets.  So the market seems overly confident that the Fed is just going to sit here – that the hurdle for a move in either direction should be great.  I’m not so sure.  We just had a violent move lower in rates (considering how rates had been moving).  We could get a violent move back, or a violent continuation.  And that’s why I like having good risk/reward trades to the upside and downside.  Because right now, this does not feel like we’re at any kind of equilibrium.  As in the scatter plot at the beginning of this section, I think there’s a good chance we move noticeably from here.

Finally, even if you thought the odds of a hike and ease for the next move were equal, you should still expect to see a positive number as the over/under.  This is because we can have multiple hikes, but we can only have 1 ease (unless we go to negative rates).  I assume the conversation for negative rates could take a while, and even if they do go, they may go in smaller increments.  So within that context, an overall 20 over/under seems low – especially when people aren’t really talking about the ease.

[1] There are some caveats to looking at historicals, especially since our situation is unique and our future path may not be a function of the past.  However, I thought the visual would be interesting.