When things don’t go as planned, I think it’s always good to take a step back and reflect. Was the March hike something that could have been expected? Maybe. You just needed to think CPI would have lit as large a fire as it did under the FOMC. I thought they would have needed some PCE corroboration. But I suppose PCE inflation was firm month over month, even though it was in-line. We learned a number of things from the events of the past week:
- We have no competitive advantage trying to guess what will happen at the next FOMC meeting. C’mon. Who are we kidding? At best, we are just making an educated guess. However, there are almost certainly people who actually talk to “Dudley” (any FOMC member or their staff) on a regular basis. While the aggressive change in the FOMC tone is a little surprising, when it does happen, we will always be the last to know. Things like selling FFJ-Q made sense as a bullish play (and that worked very well even on the selloff). Things like adding outright longs like FFX vs year spreads further out did not because of the exposure to March. I should have read my own newsletter when I wrote two weeks ago in the Value summary section, “Excluding the March meeting may be better.”
- When someone comes in and takes a 240+K FF futures position, they may know something. I wasn’t exactly sure what this was – whether it was an outright bet or a hedge. But a subset of “outright bet” includes the possibility that a gorilla had some additional inside information. Unfortunately, I had seen large front-end bets go poorly in the past, so it’s hard to say with certainty that some large positioning is based on “good” information.
- Why did the libor-FF spread come in so much? Here’s another thing we have to ask ourselves – what competitive advantage do we have in trading the front libor-FF spread, when we see NO flows? If you told me libor-FF was going to come in this much ahead of Article 50, I would have said you were probably wrong. And yet here we are. Thankfully, we kept our overall libor exposure in the Trade List to a minimum.
- Remember the “Choi Curve”? I’m not sure if you remember this chart from March 7, 2016. This chart isn’t to scale – it was meant to be figurative. But the point is that trying to fade a hike that is <30% priced is not great value, unless you have a very strong view. This is because if conditions change, the market pricing could move against you very quickly, while the moves in your favor will only happen slowly. Now that the Fed will be more active, we should keep this in mind.
- So much for letting the economy run hot. I had been a little nervous about the inflation prints since the CPI, but I thought the Fed would let us run a little hot. Growth does not seem spectacular, and inflation is still low. On balance I think the growth news headlines from the summer will lean towards being “negative.” As for inflation, I am a bit bearish on the long-term prospects for higher energy costs: everyone is making electric cars, there is improved oil extraction technology, Trump is assisting with easier production, and the Saudis are currently rigging oil markets for their equity sale. What happens with the trade policy is unclear.
- Inflation becomes marginally more important. Now that the Fed thinks the labor market is near the longer term goal (and has been stable), the pace of hikes will be a more a function of inflation (and wages). It makes predicting the path of rates a little more difficult, as inflation can be a random number generator month to month.
- It felt like there was a concerted effort to change the market opinion on a March hike. I’m speculating that the change was top-down, rather than a strange coincidence. Yellen does meet with everyone on a regular basis.
- Yellen is not so dovish. She seems to think we are in the clear and is now a more “neutral” Chair. After many years of thinking she was dovish, we should probably reset our hawk-dove meter and look at her with a new set of eyes. Yellen said nothing about “March” in her Congressional testimony. The CPI came out on the second day of testimony – perhaps she needed some time to evaluate? Or was it equities and that a crap company like Snap could have risen 60% since its IPO? Or was she moved by “presidential” Trump and his stimulus? I’m still trying to sort this out.
- What role did Mnuchin have? He and Yellen did start having regular meetings since he was sworn in office. He cannot be ruled out as an influence, and the timing of the Fed’s change-of-heart does seem to coincide (although probably secondary to the timing of the 2.5% punch in the face).
- The Fed is still stressing “gradual.” In fact, after the March meeting, nothing seems to have really changed, as the other quarterly meetings (June, Sept and Dec) are not much different from their previous trading ranges. For now, the markets are treating the March hike as a one-off. We need to make sure “gradual” is always there for purposes of our curve trades.
- The Fed may be reluctant to hike at a non-quarterly meeting. I would have thought a May hike made more sense, so that we could get some additional confirmation via the hard data. They could have signaled in March for a May hike. I just realized I am repeating what Bullard said last week. In any event, that to me is “gradual.” It felt like there was a rush by the FOMC to hike in March. I think this could make the quarterly meetings a little more valuable. I’m going to keep an eye on June. FFK-N spread contains 1.26 meetings (1 full June and pieces of the non-quarterlies around it). That 11.5bps seems a little low – let’s see how low it gets next week if we get some bad headlines.
- Portfolio reinvestments will be discussed at this meeting. They probably won’t make any portfolio changes at the meeting. They may start discussing some of the things Brainard highlighted in her speech. I think the consensus now is that we need at least two hikes (FF above 1%) before the Fed starts looking at the portfolio more seriously. It will be interesting to see to what degree the longer end bulls in the market step aside ahead of this.
We should factor in the above when considering future moves. For next week, I would think we need <<50 on payrolls for a hike to be off the table (all other things being equal). But there are some position adjustments we should consider ahead of the Employment Report…