There are five main reasons for the current situation, where things look inline for the Fed to hike later this year, and yet U6-U7 is 11bps:

 

1) We will have a recession.  I think this is a possibility.  I just don’t see this as likely.  I suppose there are always causes on the horizon: more investment funds freezing up, Italian banks blowing up, the UK economy collapsing, etc.  I’m just not sure if those things would happen to a degree to cause a US recession.  And here are TWO things that corroborate my view that these are not significant risks: (1) Equity markets are near all-time highs.  This does not equate to a recession.  (2) There is no (net) ease priced into the FF market.  This also does not equate to a recession.  For some bizarre reason, FFV6 sold off 2bps Friday, and was -3bps c.o.d. at one point.  So all eases are now off the table, and there is now about 2bps of hike priced into the September meeting.  If recession was enough of a high probability event to drive EDU6-U7 to 11bps, then you would think the next Fed move would be an EASE, and not a hike.  So the markets are pricing in a really slooow “Fed does nothing for years” environment, BUT not bad enough to ease.  WTH?!?
2) There is historical precedent to think the near-term rates should be low.  It is rare that long term rates are this low without there being some kind of recession or economic weakness.  I took a look at a chart of ten year swaps, and what some selected ED year spreads looked like.  These are all dates where a new low in the ten year swap rate had been established.  We are currently at all-time lows in ten year swaps.  Note that the 2016 swap rates are even lower relative to the 2012 swap rate because the Fed had hiked once last year (so the FF-ten year swap spread is 25bps lower in 2016).

In 2012, it’s understandable that ED1-5 spread was so low because there did not appear to be any hikes on the horizon.  However, after about a year, there was a lot more Fed activity anticipated.  In February 2016, we had that China scare and bank scare and ten year swaps got to a low of 1.52%.  The ED1-ED5 spread got to a “low” level of 22.5.  But earlier in the month on Feb 11, ED1-ED5 spread got as low as 7bps.  But this was a time where there was also 5-10bps of ease priced into this curve because of the Deutsche Bank scare.  And Feb 11 was also when the S&P hit a low of 1829.  Some people may be forgetting the “ease” and “equity” details from earlier this year.

It’s possible some traders and algos may be confused.  It will be interesting to see if people keep buying the front end in response to the long end buying.  In the past, when the ten year swap rate was low, we had ED1-ED5 spread be very low.  But there is currently no (net) ease and no equity problem.  A related issue we have is that people get used to 5s-30s or 10s-30s trading in particular ranges, and keep wanting to fade the flattening in the face of perceived economic weakness.  The markets seem insistent on pricing in a steepness to the curve in the long end that in my opinion does not belong with a much lower neutral rate.  I’m very bearish… the front end, but bullish the long end.

 

3) The Brexit process will last for 2 years and drag the US economy down for that time.

So the Fed will do nothing for at least two years.  If we have US concerns and worries over that entire period, then maybe.  But again, there is no corroboration in the equity markets and the FF markets are not pricing in eases.  The two year clock won’t start until at least September, when the new PM is elected and Article 50 is presumably invoked.  Here are two reasons to think the US won’t care about it for that long: (1) I strongly suspect that if the UK goes down a sinkhole between now and then, legislators will find some way to avoid Brexit.  It’s like if my kids buy a 50lb bag of Swedish fish with their hard-earned money, I am under no obligation to allow them to eat it (read the fine print, kids). (2) After Article 50 is invoked and “nothing” happens for a month or two (i.e.  Deutsche Bank doesn’t go belly-up, etc), the US will move on.  All we’ve seen so far is that UK real estate and possibly jobs are going to take a hit.  But this will benefit real estate and jobs in Ireland, France or Germany.  Italian banks are under stress, but this has been true for years and will be true for future years.

 

4) We have a ton of European (EU and UK) stimulus coming.

For the cross-markets traders out there, a UK ease is probably coming and UK and EU QE may be coming.  And the Japanese never like to be left out of a currency-weakening party.  So that could cause US rates to drift lower.  Maybe.  But they too have limited bullets in the short end, but more in the long end.

 

5) There could be some libor curve pressure.

I suppose a consideration could be that libor blows out.  But libor-FF spreads have been somewhat constant this whole time, and the term structure of libor-FF has been stable.  So this does not appear to be a cause of the front end flattening.  I just think the small amount of pressure we’ve seen has been from the market positioning itself for the blow-out that may never happen (i.e. there was a lot of EDU put buying last week).  And the nice thing is, if we express our bearish rate view with EDs and bullish views with FFs, this looks to offset any spread-widening risk.

 

While the above may seem like a very long list for why the front end should be flat, I don’t think any of them are as important as the resilience of the US economy and the potential for the Fed to turn less dovish.  I’m wondering if the BOE meeting next week could help relieve some of the pressure on the curve (i.e. “sell the news”).