I was amazed that FFV8 sold off as much as it did, but I am equally amazed that it rallied 8bps last week off of the Fed minutes.  I had been telling clients for weeks that the Fed Funds were too cheap – both from an additional-FFER-move perspective and a Fed hike probability perspective.  I gave reasons to think there were tail risks of the FFER coming in lower from what the markets were pricing in – including the Fed managing the FFER as it got closer to the upper end of the target range.  The Fed minutes did have a surprise in the IOER changes that will most likely be voted on at the next meeting, but that was worth less than half the move in FFV8. The rest of the minutes shouldn’t have been that dovish, if you were paying attention.

FFV8 settled at 97.88 on April 29.  Here is a rough timeline of events that had occurred since that date:

  • PCE inflation (April 30). We get lower-than-expected core yoy data (1.9% vs 2.0 expected).  This capped some of any potential inflation spike tail.
  • Fed statement (May 2). The Fed goes out of their way to emphasize “symmetric” in their statement.  When they do that, they are saying on May 2 they are willing to tolerate higher inflation.  So the minutes shouldn’t have been that surprising.  Do people know how to read?!?  The Fed is not going to have a knee-jerk reaction to a higher inflation print.  This is important because the markets are expecting the yoy inflation prints to be higher from last spring’s mobile phone price declines and other “temporary” factors that held down mom inflation last spring.
  • Powell press conference (May 2). Powell mentions that the Fed expects yoy inflation to increase because of last spring’s depressed prints and they will not overreact.  So higher inflation is already priced in, by both the markets and more importantly the Fed!  Despite these three dovish developments, FFV8 nudges lower to 97.875.
  • The Employment Report shows a lower Unemployment Rate, but also lower average hourly earnings (May 4). This continues the pattern of solid growth but non-accelerating pricing pressure.  While there is no wage pressure, I can see how a 3.9% UR print could be considered strongish, despite the lower payrolls.    So I’ll accept a move slightly lower in FFV8.
  • Libor-FF starts narrowing noticeably between May 7 and May 15. EDM8-FF narrows from -45 to -33.  So any nudging higher of the FFER from higher Libor in prior months could have been at risk of dissipating.  Now that Libor-FF is normalizing, it’s possible that the FFER could also normalize.
  • Trump pulls out of the Iran deal (May 8). Oil is a little higher, but so is the dollar.  This is just one of many headline risks that should be priced into the markets.
  • Core CPI comes in slightly soft, with the mom only increasing 0.1 and the yoy staying unchanged at 2.1% (May 10). A symmetric Fed with unchanged inflation should mean less of a need for hikes.  Another leg lower in FFV8 to 97.855?!?
  • Retail Sales comes in fractionally softer (May 15). The data is still constructive, but there does not seem to be much of an impact from tax refunds.  845!!!
  • European and Japanese data generally comes in softer. This has been the pattern for some time.  There does not seem to be a reason to think we will get globally higher inflation.
  • Emerging markets and some developed markets have looked shaky. Argentina, Turkey, Italy, Spain, oh my!  I’m not saying it’s 1997.  But things are not so rosy that some crisis premium shouldn’t be priced in.

Please tell me how any rational person could look at the above, and say that FFV8 should be lower after all of the above than on April 29.  But FFV8 on May 22 (the day before the Fed minutes) was 97.85 (3bps lower).  Wat?!?  And that’s why FFV8 settled at 97.93 (8bps higher) by Friday.  The higher yoy inflation story from last year took hold and people just didn’t bother to reassess.  In any event, we profited nicely from the move.

While this essay may have an element of a blind squirrel getting a nut, there are further implications of the market’s Fed comprehension fail.  In particular,

  • If the markets were *that* hawkish for the September meeting, how about the rest of the curve? Wasn’t the whole point of ten year US Treasuries going above 3% (and many economists’ calls of 4% yields) based on firmer inflation and continued growth?  We have constructive growth, but no real signs of the boom that some may have expected post-tax stimulus.  Inflation and wages have also been disappointing.  So where does that leave the crowded trade of being short the long end?
  • The FFER was priced to increase several “1bp” increments higher. I had previously discussed in the Trade Thoughts section why I thought the markets were overpricing this risk, and how there was tail risk of the FFER coming in several “1bp” increments lower.  There is some reason to think we may see a 1.69 FFER fixing in the weeks leading up to the Fed meeting.

I discuss these topics in this week’s Trade Thoughts section…