Tens are back near the recent low yields, and Z8-Z0 spread is back near the recent lows. This is a little surprising, but I suppose the bulls got an assist from Trumpidity. All other things being equal (ex-Trump), I would have thought we sold off going into the Fed minutes, that may discuss tapering of the balance sheet. Instead, with the announcement this weekend that Comey would testify after Memorial Day, the markets are going to be more focused on the headlines and less on the Fed.
Let’s for a moment ignore Trump/Comey/Russia, take a step back and look at the markets. Even before the recent political “noise,” there was a disconnect between the Fed and the markets. The Fed thinks they hike five more times by the end of 2018, and the markets currently think about half that. I suppose the Fed could have more recently changed their assessment because of Trump, but we’ve only heard from Mester and Bullard and they sounded roughly the same as always (bearish and bullish, respectively). We get a lot of Fed speakers next week – let’s see if any of their rhetoric has changed post-Trumpidity and the Comey news. It’s not clear if we get enough market uncertainty to change their minds – it’s unlikely the (backward-looking) data will materially change before the FOMC meeting. That’s why I keep stressing equities. Political uncertainty corroborated by shaky equity markets with meh economic data could derail the June hike.
Here’s one way to think about the current level of tens (2.23%). Remember last summer (after the Brexit vote) where the outlook looked bleak, and tens were hovering around 1.50% for two months? Well, if the Fed hikes in June (possibly a big “if”), the FF-tens spread will be the same now as it was back then! The FFER would only be 1.16 (a level that in the past would still have been considered very low and accommodative). We just had a core PCE of 1.6%, but the unemployment rate is 4.4%. By comparison, last July, core PCE was 1.3% and the UR was 4.9%. Surely an environment where the data is constructive with some domestic political noise is better than an environment where we thought Europe was going to implode? And how did we go from Bernanke’s taper tantrum to an environment where both the Fed and ECB may be tapering within the next 6-12 months and the markets don’t care? This does not compute.
I suspect there are a lot of people looking at technicals (old-timers, algos, etc) without looking at the fact that the Fed may be about to hike for the third time in 6 months. So when you look at the level of rates from 6 months ago (pre-election), you may be comparing apples to oranges. There’s a conditional probability element to the level of rates. Does it make sense to compare pre-election tens at 1.88% given the FF target then was at 0.375% (pre-election) with tens at 2.23% given a current FF target at 0.875%? The slope of FF target to tens (aka the future prospects for the economy from the current point) is about 15bps lower now that it was during Brexit. And consider that the FF target may be 25bps higher in less than a month. This seems strange from a conditional probability perspective if you go back in time, given that we are still at a very low level of rates. 1% used to be considered the “lower bound” for rates not too long ago. It would be a different story if FFs were at 4%. I don’t think we go back to the pre-election level of tens @ 1.88% with no fiscal stimulus, unless there is an appreciable slowdown in the economy. I think if you just blindly look at technicals, you don’t factor in things like this. This is because the FF target rate could be 75bps higher in a month than it was pre-election. I’m not saying we couldn’t get the economic slowdown. I’m just trying to take a step back to compare across time.
The logical conclusion from looking at rates is that a material subset of the market thinks we could go into some kind of major slowdown before the end of the year. The slowdown story makes sense in the context of the current flattening curve move, because if there is a recession in the second half of the year, then the bulls don’t have to worry about tapering, as the Fed will eventually have to engage in QE. I’ve come to this conclusion by eliminating some of the other possibilities:
- Clearly the markets don’t think anything material will happen in the next 3.5 weeks (for now), considering the June meeting is about 18.5bps priced. 5bps is a reasonable comparison to historicals, factoring in the weaker Q1 data. If the markets don’t think much could derail a hike in 3.5 weeks, that must mean that they don’t think anything noticeably destabilizing will occur with the Trump presidency.
- The markets don’t seem to want to price in a recession. The OTM ease calls on EDs are still relatively low given the collapse of the ED-FF spread on the front end.
- If the economy was just going to chug along at a 2% pace, it’s not clear to me that the Fed couldn’t just keep hiking a few times. Because most members think we need to hike another 4x or so before we get to the current “neutral.” So 2-3 more hikes could still be accommodative – especially since financial conditions have eased since the Fed has hiked.
I have been thinking more about the potential causes of a slowdown. I assume you have heard the same theories, so I’m not going into them in depth (for now): auto sales/loans collapse, consumer rolling over (weak retail sales, weak restaurant sales), no confidence of government, no stimulus from government, China blow-up, low money velocity, etc. I think a number of these indicators have predicted ten of the last two recessions. But I’ll be the first to admit that there could be some market participants with some proprietary data that may be pointing to a slowdown. Maybe. We need to be vigilant about keeping an eye out for signs of a slowdown or recession. There are also other reasons to be bullish fixed income: crisis buying, no inflation, no wage growth, technicals, foreign buying, retirement demographics, the 30+ year bull trend, carry and roll, etc. That’s a comprehensive list!
But for me, rates all comes down to what the Fed (the people who set the rates) does. And that comes down to jobs and inflation:
- If the jobs keep chugging along, I’m not sure the Fed couldn’t hike a few times even with inflation at the current low levels and an improving global growth picture. I realize the potential for fiscal stimulus has declined. However, the Trump selloff was based on a few things other than the tax plan. There is less regulation (pro-business), and there are more trade deals (see the Saudi arms deal). While the lack of infrastructure spending and tax cuts so far has been disappointing, it’s not clear to me that those things will not happen eventually with the Republicans controlling both the Presidency and Congress. It seems to me that most people don’t think we get any stimulus until next year (if at all), so all other things being equal, the risk may be for positive news on stimulus. I think if jobs keep growing, most of the other problems and risks go away.
- Inflation is (mostly) dead for now. I suppose we could get an oil-related uptick. But what is not dead is the potential for higher wages, with a pro-business President that seems to be focusing on job growth. At some point, if the unemployment rate gets low enough, we could see a rise in wages. I’m not saying wages will explode. But just getting close to 3.0% yoy growth in wages is all we need for a fixed income selloff. We are not that far off.
The rally is particularly puzzling against a backdrop of stronger European data, stronger Japanese data and higher oil. Q2 GDP seems on track and a number of FOMC members have indicated they have not factored in stimulus into their forecasts. I will admit though that what it really comes down to is equities. Assuming equities are stable and not plummet (which I realize is a big assumption), the markets seem to be underpricing the potential for near-term hikes.
Now, let’s overlay the Trump/Comey/Russia back into the above discussion. It’s always difficult to gauge what the effect of a news development will be – especially when we are at a competitive disadvantage in terms of information. The Comey/Russia/Flynn/impeachment issue reminds me of last year’s US Presidential elections where everyone was convinced the outcome would be terrible. We got an initial rally in fixed income, whereas in the longer run, we would have expected the eventual outcome to be favorable for the economy. This time around, is getting rid of a clown from the Presidency such a terrible thing? If it is in everyone’s interests to get certain legislation passed, is it not going to for petty reasons? The main difference now though from the elections is that the elections were over in less than a day. This “witch hunt” could go on for a looong time. At a minimum, we could get market uncertainty until Comey’s testimony. Then there is a chance we could get a “buy the rumor, sell the fact” issue (assuming nothing new comes out). I’m somewhat dubious Comey will say anything related to the current ongoing investigation (as that could jeopardize the investigation), but we could see the wrath of a “nut job” disgruntled former employee. So if the ED markets want to rally noticeably (not sure about direction or positioning now), we should be ready to fade at some point if/when the political and equity conditions dictate. And if we can’t rally off of this, I don’t think you want to be a bull. At the end of the day, if equities hold up, I’m feeling pretty good about the growth prospects for the economy, relative to the market.