I think of value on the curve in two ways: (1) bottom-up, and (2) top-down.  Bottom-up would be looking at a small piece of the curve and thinking about the value there, whether it’s a particular Fed meeting, or slope or curvature on a segment of the curve.  This is probably the most common way to come up with a trade idea.  Top-down would be looking at the overall level of rates and asking what implications makes sense for the shape of the curve.

On Friday, ten year yields made new “post-election” lows (starting a few days after the election results).  This has been surprising to me – especially the strength of the buying pressure.  Macro directional views can be hit or miss based on the data – especially in the very near term.  Rather than saying “this makes no sense,” it helps to take a step back and ask what the curve pricing in.  We should always be doing the top-down analysis, asking ourselves if the shape of the various pieces of the curve makes sense given the current level of rates.

Let’s pick a few points (values are approximate):

  • EDM7 is roughly pricing in an “FFER”[1] of 1.14, or 23bps or so of a move in June. We would expect June to be substantially priced, since the Fed seems to have already made up their mind to hike.  It’s unlikely the recent data has been weak enough to sway the Fed to pause.
  • EDZ7 is roughly pricing in an “FFER” of 1.28, or 14bps of a hike in 2017 after June. This is in the ballpark, since most members had three hikes this year, and the weaker data should put some downside on that third hike.  We could also get some kind of pause in hikes “later this year” on a taper of reinvestments.
  • EDZ8 is roughly pricing in an “FFER” of 1.53, or up to[2] 25bps of a hike in 2018. As I will discuss later, if you factor in a bearish tail, the markets are effectively saying the Fed will most likely not be hiking in 2018.
  • EDZ9 is roughly pricing in an “FFER” of 1.75, or up to 22bps of a hike in 2019. If the Fed is mostly done in 2018, it’s hard to see 2019 being a strong play. The recent rally is counter to my claim that the flies centered in the greens should be the highest on the curve.  If the hiking cycle is cut short (let’s assume it is for now, since this is a conditional scenario exercise), then the highest year flies may be in the reds (or even whites).

The markets are saying that the Fed is getting too ambitious with its hiking projections.  The markets only have 56% chance of another hike this year and only 1 hike next year.  Rather than saying “that looks low,” let’s instead think about the world where the approximate shape of this curve is correctSometimes it helps to put ourselves on the other side, to get some new perspective.

The new pieces of information we got this week was that inflation is low and wages are low.  Both look to be on a lower trajectory.  We also got lower European inflation, so the “ECB taper” story got weaker.  We have a drop in oil prices and commodity prices that could put downward pressure on future inflation.  It’s just looking less likely that we get to 2% inflation any time soon.  We had a drop in labor force participation that is not good for the US growth story.  That’s a lot of bullish new news in just one week.  And I’m not even including Trumpidity – the Comey risk, the debt ceiling risk, the budget impasse risk and of course any new episodes of Trumpidity.  So considering all of this, does it make sense for the FOMC to hike as many times as they think they will?  The Fed does not think GDP will increase past 2% in the long run, so they have “reasonable” growth expectations.  However, the Fed seems confident inflation will rise over the next year or two, despite the recent evidence.  The market is saying, well if inflation is already low and there are some other downside forces, does the Fed need to hike much more?  So the bullish argument is not “crazy.”

Brainard is already taking about reevaluating Fed policy if this continues, and so the Fed will be data dependent.  It’s somewhat unlikely the Fed makes some kind of major policy error, if a Governor is currently warning about potential downside inflation risks and we don’t get an uptick in inflation.  It now seems somewhat absurd that the Fed hiked in March, and you could argue that we don’t need this hike now in June.  But when we are about 100bps from “neutral” and rates are accommodative, it’s not the end of the world to take some of it back.

Could an over/under of 1.6 hikes for the next 1.5 years after June make sense right now?  Maybe.  That means the Fed will probably hit the brakes about 25-50 bps from the “neutral rate” (perhaps less if the neutral rate has recently lowered noticeably).  This means they probably remain slightly accommodative, and may not be tapering at the end of the year.

The next thing we have to ask ourselves, is if the shape of the curve makes sense, give the above bullish case, where is there value and where would a further rally come from.  At this point, the main candidates for value if you are a bull are (in order):

  • A general bull flattening. In a no-inflation, yield grab environment, why not grab the most you can?  A former colleague calls owning bonds the “one trade to rule them all.”  So we can see the entire curve flatten, after EDM7.
  • 2019 slope. The year spread curve between EDZ9-Z0 spread and EDU1-U0 spread is almost a straight line.  So those year spreads would probably just join the general flattening above and move in tandem.  The next year spread to join that party would be the EDZ8-Z9-like spreads.  If there is only one hike in 2018, it’s seems unlikely 2019 should have much more above what is in 2020 and beyond.  This could be the next to adjust and go lower on a rally.
  • 2017 & 2018 hikes. The growth data so far has been constructive.  But we are news and data-dependent.  These could be the last to go.  The major thing to watch for is a increased eases being priced in.

I don’t disagree with the potential for the bullish view to materialize…  I just happen to think the current levels severely discount the bearish tail.  For example, even if you thought the Fed hiked ZERO times next year, you still have to assign some non-zero probability to the Fed hiking 1, 2, 3 and 4 times next year.  The Fed median is for 3 hikes next year, there are four members calling for 4 hikes next year and another four members calling for over 4 hikes (I am ignoring these latter four folks).  As a very simple example, a 60% chance of zero and 10% chance of each of the other hiking scenarios gets us to 25bps,[3] which is what the markets are pricing in.  I’m surprised that the markets can be that sure of no move or no tail.  I suppose you could argue for an ease next year, but a 10% chance of one ease, 50% chance of zero hikes and 40% tail still gets us to 22.5bps.  FWIW, there is almost no ease priced in currently in the options markets.  When one tail is live (the bearish one), and the other tail is not (ease), it’s strange to think this could be the equilibrium level.  We currently have a very benign rates environment priced in.  And that’s why I can’t get on board with this rally.  Inflation perceptions can change on a dime – especially things like oil prices and commodities.  But we are at key technical levels, so it will be interesting to see if we get more follow-though.

We probably need to factor in something for lower rates in Europe and Japan putting downward pressure on the longer-end US rates.  So the markets may not be pricing as few hikes as it appears further out the curve.  If this is the case, we may want to stick the front part of the curve (on bearish trades), which will converge more quickly with Fed actions.  We’ve had a lot of interesting developments on the short end of the curve.  I’ll discuss the confusing possibilities further in the next section.

[1] Keep I mind this is not all the FF rate, and also includes things like term premium, etc.

[2] The ED-FF spread starts getting noisy around here, and we need to factor in more things like ED convexity and the shape of the swap curve.  But this is just a rough approximation.

[3] 25bps = 60%(0) + 10%(25) + 10%(50) + 10%(75) + 10%(100)  You could argue the probabilities should be bell-shaped, but this is a simple example, and we did ignore the 5+ hike folks.