After a number of snoozer central bank meetings, we had several surprises from the Fed and ECB. These surprises have caused a number of minor regime changes on how some local parts of the ED and ER curves should trade. Here are some of the key things that will affect the yield curves going forward:
- The Fed removed forward guidance to remain for some time below longer term neutral rates. This was expected at a meeting later in the year, but it was a little surprising it occurred so soon. The Fed was not going to hit “neutral” for a couple more hikes. There’s a good chance the FOMC had advance access to the Retail Sales number released on Thursday, as they mentioned that household spending had picked up in the statement. It’s a little disconcerting that the Fed is envisioning having to slam on the brakes on the economy at this odd juncture. The only solace is that I am starting to sense a divide between the “economist” members and the “business” members. The economists seem more tied to their overshoot models (like Dudley), and the business members seem more focused on not inverting the yield curve (like Kaplan). Powell is a business person. But right now, some parts of the ED curve have inverted, and it’s not clear to me which group of the FOMC will win the tug-of-war.
- The Fed will have press conferences at every meeting, starting in 2019. I think a subset of people in the markets knew this earlier because the Jan 2019 meeting shot up after the announcement (to 4) but is now at the pre-announcement levels (2.5 offered). The May 2019 meeting shot up to 4.5 and stayed near there, but that could just be from the strong retail sales and hawkish Fed. It should be noted however, that these non-quarterly meetings started moving higher a couple of days before the FOMC meetings. We should look at signs of further “information leaks” before future FOMC meetings. While a press conference at every meeting could imply a greater chance of a hike at a non-press conference meeting, this also decreases the odds of a hike at the quarterly meetings starting in 2019. This is because the chances of a hike at any pair of FOMC meetings is probably not materially changed. When the markets are pricing in less than two hikes for 2019, it’s highly unlikely for there to be hikes in consecutive meetings. Part of the logic of starting next year could be that the Fed will hit the current “neutral” rate later this year, so the “easy” hikes will be over. The hikes in 2019 could involve more discussion and could be more dependent on how their perceptions of the longer term neutral changes and the appropriate rate path based on the data.
- The ECB will end QE at the end of 2018. But they will keep reinvesting the portfolio. From what I could tell, only about 1/3 of economists thought the ECB would make this announcement at the June meeting (a majority seemed to think July). Normally, this should have caused the long end to sell off, but…
- The ECB will be on hold at least “though the summer of 2019.” This was shocking that they would commit to not moving for so long and at the same time remove QE. I think this must have been a compromise of some sort between the hawks that wanted to normalize QE, and the doves that were concerned about downside economic surprises. I know the ECB could change their minds depending on the data, but if they are saying that they are going to on hold through next summer (based on current information), then ERM9 should be the bottom of the fly curves. In other words, this statement will cause a large kink in the fly curve around ERM9. Interestingly, since Draghi’s term ends in October 31, 2019. This keeps alive the “hike at his last meeting (September 2019) and ride off into the sunset” theory. Bernanke and Yellen both took steps towards further policy normalization before stepping down. Even if Draghi doesn’t hike, the next ECB President will surely be more hawkish than Draghi.
How do these minor curve regime changes affect trades and positioning? That is the topic of this week’s Trade Thoughts section: