[Since the Fed meeting is over, I thought I would post one week earlier my thoughts from last weekend on the various meetings. Because the Fed statement came out as I had thought, the analysis is still the same. Over the weekend, I’ll post a rehash of the “strategy summary” email I sent out today in the Forum: http://www.curveadvisor.com/forums/topic/2016-trade-discussion/.]
Next week is the not-so-anticipated Fed meeting. It makes sense to take a look at what is priced in, so that we can get an idea of what people are thinking and formulate a plan for how we want to approach value. Let’s go over the meetings this year:
APRIL. We see the usual ~1bp from all the lottery-chasers and people needing to hedge the extreme event. I think the odds are “zero” (without it actually being zero).
JUNE. I do not see them hiking in June with Q1 and Q2 GDP expected to be around a ~1% yoy pace. Even the NY Fed thinks neutral growth is only ~1.75% and we are below that low hurdle. We basically would have to go perfect-perfect on the next two payrolls (in terms of big upside surprises). I’m not saying that couldn’t happen, but the last THREE LMCIs have all been negative (averaging -2.2). The LMCI had only been negative once in the previous 42 months, prior to the last three months. Where is the monster employment report going to come from? We’ve been chugging along, but the pace has slowed recently (not accelerated). So the Fed will be patient. I also don’t see them putting the balance of risks back in next week, unless their criteria for the balance of risks changed from the April meeting. I think the Fed is basically going to be “split” again on the outlook. Because if you were a dove, you will still be a dove.
An interesting side note is that if you were one of the 7 (out of 17) that wanted 3 or 4 hikes in 2016 (mostly Bank Presidents) AND you think it’s highly unlikely the Fed hikes in consecutive meetings in this environment (as I do), then no hike thru June means those folks were wrong. Shocker. You can’t have 3 hikes in 2 quarters without hiking in consecutive meetings. I don’t think this is a factor, since it’s mostly the non-essential people with the 3+ dots. The markets certainly don’t think 3 hikes were ever likely. This is an interesting segue into July…
JULY. It’s noteworthy that July is priced almost as much as June, even though it’s a non-quarterly meeting. Typically the non-quarterlies have been very low. Most members must be resigned to not hiking in April. But I would think if there was a pick-up in data, the 3 and 4 hike members could start screaming for a hike in June. I still don’t see a hike in June, but maybe the doves in power throw them some kind of bone, and relent to a bearish signal at the June meeting to warn the markets for the rest of the year. This could open the door for July. Maybe. But first we need to see a noticeable sustained pick-up in data in the next two months, so let’s not get ahead of ourselves.
SEPTEMBER. 5.8 seems low, but it seems relatively reasonable. And if you think the Fed hikes twice in 2016 and subscribe to the “Fed won’t hike in consecutive meetings” theory, then you need a hike by this meeting to get to 2 hikes by the end of the year.
NOVEMBER. This has tanked. As mentioned previously, this does not seem like an economy that’s going to require a hike less than a week before the election. In this environment, the Fed does not have to hike at any one particular meeting. You can always hike before or after. Besides, the FOMC are a bunch of Democrats, Yellen met with Obama, Trump doesn’t like Yellen, Brainard contributed again to Hillary and there was a full moon on Earth Day, so pick whatever conspiracy theory you want. I think it’s going to be hard to get the markets on-board with this hike, and that means the Fed has no reason to hike. But there’s always the lottery value.
DECEMBER. This has been my #1 choice for a hike for 2016, and this is reflected in that it is the highest meeting. If the Fed is dovish, there’s plenty of time by December for the data to recover. If the Fed is hawkish, they could hike once during the summer and once again later in the year. Win-win.
None of the individual meetings are priced particularly high. June thru Sep getting about 4 to 1 seems like a reasonable bet if you have a strong view on a particular meeting. This somewhat follows from the bottom-up approach from the Choi Curve, since the meetings (other than maybe June) won’t decay much and there is a potential for the rapid acceleration of a particular meeting.
However, there is something that doesn’t quite sit well with me. It’s because you also need to factor in some top-down constraints (a.k.a. cumulative pricing). My view is that the Fed has a low probability of a hike in Q2, a medium probability of a hike in Q3, and a medium-high probability of a hike in Q4. This all assumes data starts getting back to “trend.” So when I take a step back and look at Q2 + Q3, there are 15.7 bps (a 63% probability of a hike). People who are very dovish are not going to look at what is priced into an individual meeting, but the cumulative meetings. And to them, 63% may seem high. And if this cumulative probability were to get to 75%, I would think many of them would start piling in. At that point, you would be getting that magical 3 to 1 payoff that people seem to look for in trading. When you step back, is the Fed really going to hike TWICE by the end of Q3? Again, I’m not saying it couldn’t happen, but TWICE?!? I don’t see this happening… and I’m bearish! (relative to the market) You would need June and September (assuming the Fed doesn’t hike consecutively). That’s being a little too fine for me.
Here’s another way to sanity check. Say you were given a choice… say you had to pick between the hikes in Q2 and Q3 and the hikes in Q4. Which would you take? Well, obviously Q2 + Q3 has twice as many meetings, but let’s ignore April (since it is “zero”). So let’s compare (Q2 + Q3) and (1.5x Q4), which are comparing a similar number of meetings. Which looks better to you? [Cue Jeopardy music] Keep in mind that Q2 should be low – is the Fed really hiking in
< 2 months, on the back of a 0.3% GDP print?
The markets currently have (Q2 + Q3) = (2.2x Q4) ! Did I miss some memo about the economy on a heater? To be honest, I think it’s a toss-up between (Q2 + Q3) and (1.3x Q4)! It’s like I’m getting a Dec meeting for free! What is going on? Surely the markets aren’t thinking Rosengren is still a moderate dove? Because he turned to the Dark Side a few months back, if it wasn’t obvious. And he’s a Bank President!
You may have noticed that I’ve had some “long EDU6” plays in the Trade List. I’m going to keep looking for good risk/reward plays around this theme. I think a “moderate” recovery is about as good as you can hope for in the near-term given the current backdrop. You are going to need more time with moderate data to develop the confidence for a hike.
[This was originally published in the April 25 issue of the Curve Advisor.]