I finished that article on regime change for a trade magazine, and it has been approved. It should be published some time in the next few weeks (I’m guessing). There was one part of it that I thought was particularly interesting that I wanted to highlight because it seemed very relevant to the current market. The market positioning has been “overly bearish” for some time, and partly as a result, the markets have not been able to sell off for most of this year. EDZ0 is UP 2bps on the year, despite much-better data and a hawkish FOMC. That’s got to be a head-scratcher for bears, but I think misinterpreting historicals are one of the causes.
The jist of my article was that algos are *overly* dependent on historicals, and are less likely to factor in the drivers that may have changed in the current environment, as compared to the historicals. But I suppose most human traders (including myself) can also be overly dependent on the historicals. The article highlights a number of major and minor regime changes one should factor in when looking at historicals to look at the present.
The two factors I wanted to highlight today are:
- The Fed has lowered its longer run Fed Funds target rate dramatically over the past five years. Just in the past two years, the mean longer run FF target rate has dropped 83bps. This means the theoretical value of the long end is 83bps lower than two years ago. This is “all other things being equal,” and we know all other things are NOT equal because of ECB QE and Japanese QE. One of the things I am unsure about is whether the longer term rate (as estimated by economists/Fed) is more structural or is more subject to (frequent) change. Could the removal or QE, or stopping Fed portfolio reinvestments, or higher inflation expectations, or change in regulations, cause a change in the long run “structural” FF rate? If so, by how much? It’s not clear to me if economists are just data-fitting the historical data we have recently seen.
- The Fed is now in a hiking regime. Previously, we were in a neutral regime. The curve is going to look differently when the Fed is in the middle of a hiking cycle than when the Fed is supposed to hike “eventually.” Most importantly, the Fed has already hiked twice! So anything related to the level or slope of rates will be offset by 50 basis points from the historicals.
Just taking those two things, you can see that there is over 130 bps less room for the curve to steepen, as compared to two years ago. So it is not reasonable to think that reds-golds pack spread would get to over 300bps, as we saw a few years ago. There just isn’t room on the current curve with the Fed having hiked twice and the neutral rate coming down 83bps. For you to have a view that we could steepen that much, you need to think the Fed eases (and probably to negative rates) and/or that the longer run FF rate increases.
Just as a very rough back-of the envelope estimate, let’s take the 133bps from just those two factors and adjust the current spreads accordingly. If we divide the 133bps into the four pack year spreads in the whites through golds, we get that each year spread will be lower by 33bps! Depending on the part of the curve (see next section, where I discuss a better adjustment), those 33bps added to your year spread will make the current level look much more “reasonable” relative to the historicals.
I’m not saying we couldn’t get a very bearish steepening event, like Trump causing $10+ trillion of new US debt over his term, or the Fed liquidating their portfolio, or the ECB tapering, or getting high inflation or the repeal of Dodd-Frank possibly leading to positive 30 year swap spreads. And if you think things will evolve such that the longer run FF rate should be much higher, then this review will only strengthen your view. However, you probably should factor in that these two factors need to be adjusted for (in some way) to compare the current curve to past technicals or charts.
So don’t just look at the historicals like they were somehow written in stone. You should know you are comparing apples to oranges when you look at the data from more than a year or two ago. You should look at the curve from this new “different regime” perspective of looking forward, rather than relying on just a backward look.