We’ve had an interesting few months, where we rallied a ton, sold off some and then rallied back.  I thought this would be a good time assess what the markets are pricing in.

160411 Z68Am I the only one thinking it’s bizarre that the lowest year spread is Z6-Z7 (and U6-U7) and the highest year spread on the ED curve is EDZ9-Z0 spread (and all the other blues-golds spreads)?  Yes – the data has been a little weak.  But if you asked me if I would rather take EDZ6-Z8 spread at 43 or EDZ8-Z0 spread at 52, I would say definitely the former.  I’m surprised that the differential is around 20%.  And if this was the Price is Right, and I had to guess which price went with which spread (and I did not see the markets at all this year), I probably would have guessed EDZ6-Z8 was 52 and EDZ8-Z0 was 43.

You may be saying “but that’s what the curve typically does when it prices out hikes – it prices out the near-term ones and prices in the further ones.”  Yes.  But when the Fed still sees itself on a gradual hiking path, this is strange.

The next few hikes are THE “high probability” ones.  Granted, I have no idea when they will happen.  What do I mean about the “high probability” ones?  I mean, after the Fed gets to around 1-1.5% in the target rate (probably where the current “neutral funds rate” is), you could argue they really don’t need to hike again until Europe and Japan recover (and end QE), all other things being equal.  You all know I think Japan is NEVER going to recover[1], so let’s say “until Europe recovers.”  And I suppose “China recovers” could be at least as important.  I think near-term hikes (the next few years) are more likely than the longer term hikes.

If I had to guess how this curve development happened, part of it is probably the markets thinking the Fed is more dovish than they are, and another part of this could be a bunch of historical models/algos gone “wrong.”  Because normally, if tens are at 1.72%, it would be reasonable to think the Fed is on hold for a looong time.  Historically, this has been true.  But I don’t think this is the case now.  We just have a lot of people buying the long end and the Fed may not hike all the way to their long run target.  The Fed still thinks they are hiking this year (and next).  Greens now look rich relatively to me.  I’m going to look for ways to fade this next week.  The tricky thing is, if the historical models/algos are pointing towards a long pause based on tens, what will get them to stop thinking this way on a further rally?

[1] It’s pretty hard to “recover” when a third of your population is supposed to disappear, your fertility rate is one of the lowest in the world and you don’t embrace immigration.  And the areas they were once dominant in are more competitive (consumer products, technology, metals, etc).