This week the FOMC meets on Tuesday and Wednesday. Most recently released minutes suggest that the gradual cessation of the $120BN in monthly bond buying ($80BN in US treasuries and $40BN in mortgages) is getting closer. Given the history of prior efforts to wean the bond market off Fed support, popularly referred to as “taper tantrums,” careful consideration is being given to every aspect of the decision.  

Unilever added to the list of companies reporting pricing pressure last week. CEO Alan Jope reported that, ““We are facing very material cost increases,” He provided examples, noting year-on-year increases in palm oil (up 70%), soyabean oil (up 80%), crude oil (up 60%) and ocean freight (up 40%).  

Procter and Gamble, which is in many of the same markets as Unilever, has already warned of price hikes to come in September. Operating chief Jon Moeller said,” “This is one of the bigger increases in commodity costs that we’ve seen over the period of time that I’ve been involved with this, which is a fairly long period of time.” 

The housing market continues to be red hot. One client told us he plans substantial increases in rents on properties he owns on Long Island, NY. This is in part to compensate for the difficulty in evicting delinquent tenants. Although the CDC’s eviction moratorium, which has been the subject of court challenges, expires at the end of July, New York State has issued their own moratorium.  

More expensive real estate is pushing up rents. Data from Zillow shows that rents are up 7% across the country from a year earlier.  

House prices are up too. The most recent Case-Shiller US National average rose 2.1% in the previous month, +14.6% for the year. It is the topic of cocktail conversation among the lockdown-liberated. The Fed’s $40BN a month of mortgage buying is boosting home prices by holding mortgage rates down. 

The FOMC will discuss the frothy housing market but may draw comfort from other data. For example, Owners’ Equivalent Rent (OER) is showing a 2.3% year-on-year increase. As we’ve noted, OER is drawn from a survey that asks homeowners what rent they believe their house would command in the market (see Why You Can’t Trust Reported Inflation Numbers). Most homeowners have only a vague notion of what this figure is, or OER would be rising along with actual rents and house prices.  

Moreover, how is the FOMC to regard OER if it belatedly starts rising, especially if the actual market for housing and rents starts to cool? OER is never tested against the market, since it’s not based on actual transactions. A homeowner can theoretically offer an aspirational rent estimate in response to a survey from the Bureau of Labor Statistics even if their home would never rent at that level. It’s likely that this dovish FOMC would dismiss rising OER as inconsistent with other data and not reflective of cash transactions. So it’s a useless component of the CPI, albeit a significant one with a 24% weighting. The Fed prefers the index of Personal Consumption Expenditures which uses OER but at a smaller weight.  

Dumping the OER concept and relying on actual cash expenditures on shelter would usher the Fed into the world the rest of us inhabit. 

The FOMC may also draw some comfort from falling bond yields. Ten-year inflation expectations, derived from the difference between nominal and real yields on US treasuries, have fallen from 2.5% in late May to 2.28% currently. Fed chair Jay Powell has repeatedly assured us that the rise in inflation is transitory, so he may point to the bond market as confirming this belief. The FOMC remains convinced that there remains plenty of slack in the labor force. Interestingly, the non-partisan Congressional Budget Office believes we are closer to potential GDP, which in their view implies less economic slack than the Fed believes.  

Chair Powell may peruse recent work from Citi Research, which takes monthly gross issuance of US treasuries, deducts redemptions and Fed buying to arrive at the net supply to be absorbed by other buyers. July’s $94BN of net supply is the lowest figure of the year, a third less than the monthly average of $150BN. Citi argues that bond scarcity was behind the recent drop in yields.  

At first, I thought this seemed too simplistic. Surely the buyers, who are largely central banks and sovereign wealth funds and others with inflexible mandates, must nonetheless be aware of this seasonality and adjust their buying accordingly. But then I realized that our own central bank doesn’t even do that. Their monthly purchases are fairly consistent.  

In July, Fed buying will take up 85% of net supply, versus 54% on average during the year. In May the Fed bought up only 45% of net supply. 

Therefore, the recent drop in inflation expectations that will cause some relief among FOMC members may be in part their own doing. Combined with their failure to accurately measure housing inflation, the FOMC looks increasingly divorced from the real economy.   

September is a heavy issuance month, and the Fed will only be buying around 44% of net supply. If they’ve begun tapering by then, it could be even less. Managing portfolios while the FOMC tries to elegantly exit their ongoing partial debt monetization will require deft risk management for the rest of us.  

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

 

Bob Rubin was US Treasury Secretary from 1995-99 under Bill Clinton. Early in his tenure, the US$ came under severe downward pressure. Market pundits kept calling for the Treasury to provide US$ support, to stem the slide. This evoked memories of 1987, when a growing trade deficit caused persistent US$ weakness which pushed up bond yields and eventually led to the October stock market crash.

Relying on his almost three-decade career at Goldman Sachs which culminated in co-chairman, Rubin waited, allowing the US$ to continue falling. He recognized that even the US Treasury couldn’t stand in the way of the FX markets. He waited until the US$ sell-off paused, and then retraced for a couple of days, in the kind of move analysts call a “healthy correction.” Just as the small bounce is the US$ was testing the conviction of shorts, the Treasury launched a coordinated intervention with Japan, Germany, and Switzerland. The consequent trading losses inflicted on FX speculators took a while to heal, and traders were more cautious about shorting the US$ afterwards.

Today’s Federal Reserve does not possess such a deft hand. Perhaps it’s because the FOMC has to agree on policy, constraining them to decisions at their meetings rather than allowing chair Powell to act opportunistically. In any event, the Fed is missing the opportunity to begin an elegant exit from its $120BN monthly bond buying program. Surely the ten-year treasury note yielding 1.3% is proof of sufficient demand elsewhere and that the continued debt monetization is no longer needed.

If Bob Rubin was Fed chair, his planned exit from the Fed’s bond buying would be timed for when the market no longer needs it. Given a choice between tapering now, when yields are falling, or later when continued economic strength is driving yields higher, the former is clearly less disruptive.

But that’s not the FOMC’s game plan. Their strategy is to exit when they see full employment and 2% inflation expectations (or higher). We are to expect ample and timely communication, but they will nonetheless most likely be reducing their buying into a falling market. There’s probably no easy way to scale back over $1.4TN in annual bond buying, but the FOMC’s plan looks decidedly market-insensitive.

Eurodollar futures are priced for 0.75% of tightening by the end of 2023. The most dovish of the blue dots on the Fed’s Summary of Economic Projections (SEP) expects policy to still be unchanged by then. Although the median is higher, the FOMC’s composition will likely become even more dovish over the next year (see Trading Futures With The Fed).

Jay Powell has promised that, if required,“… we will use our tools to guide inflation back down.” This is the bare minimum commitment of any Fed chair, and he’d clearly rather not have to. Powell is all-in on the belief that the inflation rise will be transient.

It may be, in which case the 1% yield on December 2023 eurodollar futures is too high. But if the FOMC is wrong, and inflation expectations become anchored well above 2% as a reasonable reaction to rising prices, the Fed will likely have to move more than just once a year, which is what’s now implied by the 52bps spread between Dec ‘23 and Dec’25 eurodollars.

It’s hard to envisage the type of economic environment by then that would justify the slothful monetary tightening currently priced into the market. It would likely require a persistent shortfall in employment, inflation back below 2% and little or no new fiscal stimulus, an unimaginable degree of Congressional restraint.

The SEP blue dots suggest a tightening pace of twice that.

The yield curve it too flat. It’s currently possible to bet with the Fed’s forecast of a very slow normalization of monetary conditions in a trade that should also work if it turns out they’re moving too slowly. It’s a way of betting with the Fed while having insurance in case circumstances move against them. The trade is to go long Dec ‘23 eurodollar futures and short Dec ‘25 futures, at a spread of 52 bps.

Inflation concerns are coming up regularly in conversations with investors. Wells Fargo recently calculated that 60% of the pipeline sector’s EBITDA is subject to tariff escalators linked to PPI, which is likely to exceed 5% this year. For liquids and NGL pipelines that could add up to a more than 3% increase in cashflows in 2022 – a benefit that requires no incremental capex, and is not just a one-time gain as it’ll become embedded into the tariff structure. We believe midstream energy infrastructure offers one of the most attractive ways to invest for inflation protection.

Finally, we liked a WSJ op-ed (see The Climate-Change Agenda Goes Out With a Bang) that noted the increasing pushback from voters around the world against the agenda of environmental extremists because of cost. Swiss voters have rejected an increased fuel tax; Britain’s cabinet is split over previously announced plans to ban gas-fired home heating; a proposed French diesel tax in 2018 helped create the “yellow jackets” protests. From Joe Biden on down, political leaders have downplayed the cost of the energy transition, instead of explaining that if something’s worth doing it’s worth paying for. Hopefully this will introduce a little more realism into policy debates.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Last week’s big story was the sharp drop in bond yields. Ten-year treasuries dropped below 1.3% on Thursday, down 0.30% on the month. Big moves in bonds usually have a visible catalyst, but there was no obvious driver of last week’s move. Inflation expectations dropped somewhat, which is typically reflective of a change in the economic outlook. But around half the drop in bond yields has been caused by falling real yields, which are typically less sensitive to economic data. Today’s investors in ten-year treasuries are willingly accepting a loss, after CPI inflation, of almost 1%. Non-commercial buyers, including central banks and pension funds with rigid investment mandates that require fixed income allocations are setting bond prices today.

Eurodollar futures continue to provide a fascinating counterpoint to the FOMC’s Summary of Economic Projections (SEP). The infamous “blue dots” from the SEP are overlaid on the eurodollar yield curve below. They show the median forecast for the Fed’s overnight policy rate – the blue dots provide annual readings for 2021-23, and a long-term forecast. So we’ve assumed the equilibrium real rate of 0.5%, what the FOMC calls “r*”, is reached by 2026. With their 2% inflation target, that results in a 2.5% neutral Fed Funds rate.

We’ve also added in Fed chair Jay Powell’s blue dots. The SEP doesn’t disclose dot ownership, so we’ve simply assumed he’s the most dovish dot in each year which is consistent with his public comments.

If Jay Powell was allowed to trade eurodollar futures, he would surely bet on a steeper yield curve from 2023-2025. Even though he constantly warns us not to pay too much attention to the dot plot, he provides a forecast himself like the other FOMC members.

We’re told they will move slowly in raising rates, and the most dovish dots are 0.75% below eurodollar yields for 2023 even after the recent bond rally. But five years out even the most dovish FOMC member is 0.25% above eurodollars. The discrepancy was more pronounced on Thursday morning when the bond market’s recent rally faltered.

Although FOMC doves think the market is ahead of itself in anticipating the beginning of monetary tightening,  it’s also too relaxed about the pace of tightening once the FOMC gets started.

This shows up in calendar spreads. On Thursday the spread between December ‘23 and December ‘25 eurodollars narrowed to 0.55%, implying the Fed will be on a pace of barely more than one 25bps hike annually during that time. This is historically very slow, and at odds with what FOMC members expect. In March, the market was priced for almost five tightenings over this two year period. By the end of the week, this spread had widened back out to 0.65%.

For those who are familiar with the colors of each year of futures, the Jay Powell trade is to go “long the green Dec gold Dec spread.”

Betting against the FOMC made sense early this year, when the yield curve was too flat. Six months ago the market was priced for only a one in five odds of a tightening by the end of next year. Today, seven out of 18 FOMC “blue dots” are forecasting such, and the market has adjusted accordingly.

But the opportunity is shifting towards later rather than sooner, which is in line with Fed chair Powell’s view. Former NY Fed president Bill Dudley noted that the employment situation is likely to remain unclear until Federal unemployment benefits fully expire in September and children finally return to in-person school. So it’s going to be at least another couple of months before the Fed can conclude “substantial further progress” towards full employment has been made.

Being an inflation hawk has gradually gone out of fashion, not least because persistently low inflation has rendered such a stance out of touch. But even today’s dovish FOMC expects to raise rates within two years – their internal debate will be one of speed.

Joe Biden will have an opportunity to influence the FOMC’s composition. Fed chair Powell is up for reappointment next year and looks likely to stay. Vice chairs Richard Clarida and Randal Quarles are also both up for reappointment, and one of the seven Fed board seats is vacant, with a term that expires in 2024.

This offers the president an opportunity to modify the FOMC somewhat to reflect his views. Don’t expect anything so crass as public advice on monetary policy from the White House, but subtle pressure out of the spotlight is likely. This makes a slow pace of monetary tightening more likely, because the FOMC’s dovish tendencies will be reinforced.

Chair Jay Powell is likely to have a say in any appointments. He’s already suggested that monetary policy has a role to play in reducing income inequality. There are many considerations the FOMC could include in setting rates, and they’re all likely to lead to more dovish outcomes than a simple focus on inflation.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

 

Last week a friend called to wish me Happy Independence Day. He added “Down with the British” in recognition of my immigrant status. My accent betrays my British childhood, even though I moved here in 1982. July 4^th barbecues usually provoke a few joking reminders about beating the British. The obvious response is that had the War of Independence instead been the defeat of the colonial uprising, there would have been little reason for me to emigrate from the UK some two centuries later.

It is typically American that the descendants of that war’s losing side are so readily welcomed, especially on the anniversary of its kick-off.

While the U.S. will fall short of its goal to give at least one dose of Covid vaccine to 70% of adults, we can still celebrate that life is almost back to normal. After a stuttering start, once America took on Covid we were going to win. America always wins. As Churchill once said, “You can always count on the Americans to do the right thing after they have tried everything else.”

The fact that international travel is virtually impossible is a reminder that while Covid may be over in this country, it remains a dominant feature of everyday life in many others. Much as I would have loved to travel to London and watch England beat Germany at Wembley last week, testing and self-quarantine requirements made it impractical.

The economic consequences of Covid are still with us. The Fed’s full-on monetary stimulus and bond buying are barely different from a year ago even though the economy has come roaring back. Friday’s payroll showed another 850K jobs added and the unemployment rate only edged up because more people are being drawn back into the workforce. 1.6 million people report the pandemic is preventing them from looking from work, down from 2.5 million a month ago. The question hardly needs asking any longer, and the end of Federal unemployment benefits will help.

Nonetheless eurodollar futures prices rose, reflecting slightly lower tightening probabilities.

OPEC fears a crude surplus by the end of 2022, which is complicating their discussions to continue phasing out the supply cuts they implemented in May of last year. They’re evidently not too concerned about high oil prices weakening demand. By contrast, the Fed remains at full throttle, providing ever more stimulus.

Finally, for those enjoying the Euro 2020 football tournament, the photo reminds that the game doesn’t only produce moments of brilliance.

Happy Independence Day.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Interest rate markets became a lot more interesting this year. Uncertainty around inflation and the Fed’s likely response are creating undulations in the yield curve whose precise forecasts are sometimes a trading opportunity.

For example, late last year the spread between the December ‘21 and December ‘22 eurodollar futures contracts was around 5bps. Since the Fed typically moves its policy rate in 25bp increments, this projected a one in five probability of one tightening in 2022. This turned out to be too low. A rebounding economy combined with profligate fiscal stimulus has led to upward revisions to growth and inflation this year.

The FOMC’s Summary of Economic Projections (SEP) showed that FOMC members had brought forward their estimated timing of higher rates. By early June the spread was at 20, showing an 80% of a 2022 year-end tightening. Six months ago, taking the one in five odds by buying the spread (long December ‘21 and short December ‘22) was a good bet.

A week ago, following the June FOMC meeting, St. Louis Fed president James Bullard revealed that he is forecasting a 2022 tightening. He is one of seven (out of 18) FOMC members with that view, two of whom expect two tightenings. So we know where Bullard’s blue dot sits. Our eurodollar spread moved further, and now sits around 34 where it is priced for at least one tightening by the end of next year and around a 40% chance of a second.

Imagine sitting down with FOMC members while they tell you whether eurodollar futures are correctly priced or not. Were James Bullard to visit SL Advisors’ GHQ and enter into such a conversation, he would likely endorse the market’s pricing. Getting here was the Bullard trade. He favors a faster pace of tightening than some other FOMC members.

The slow, or dovish camp is led by Fed chair Jay Powell. 11 of the 18 FOMC members expect no tightening next year. If Powell accepts this invitation to visit SL Advisors and discuss eurodollar futures, he would say that the market is wrong. He goes to great lengths to downplay the significance of the blue dots in the SEP.

Powell regularly reminds us that the unemployment rate in February 2020 just before Covid was 3.5%, so today’s 5.8% suggests we remain far from full employment. We’re still over 7 million jobs short of where we were, and Powell wants to give those people every opportunity to return to the labor force. He expects inflation to moderate from its temporarily high level and sees little likelihood of the Fed having to hike rates next year. The market is currently skeptical of this view.

The Bullard view is currently in the ascendancy. He favors a faster path to higher rates, which by moving earlier in the economic cycle suggests less need for tightening later on. Eurodollar futures more closely reflect this outcome. Fed chair Powell may be among the majority of FOMC members, but financial markets disagree. What always makes such contrasts especially fascinating is that futures prices are telling the FOMC they disagree with their forecast. It would be bold of a bond manager to tell the Fed chair’s he’s dead wrong, but the market’s collective estimate is doing just that.

By 2023 most FOMC members expect higher rates, but there are still five who forecast no hike and two looking for just one. Powell is likely in one of these two groups – it therefore must be galling to have watched the December 2023 eurodollar futures yield climb almost 30bps from where it was prior to their meeting. At 1.15% it’s pricing in 3-4 tightenings, whereas Powell is likely expecting only one. He must think December ‘23 futures are cheap.

Powell might be right, and certainly has more influence over the outcome than most others. His term as Fed chair ends in February, but if he’s not reappointed an equally dovish replacement is likely. The bond market is no longer as powerful as when Clinton’s campaign manager Jim Carville said he’d like to be reincarnated, “…as the bond market. You can intimidate everybody.”

What this means is that while we’ve had the Bullard trade, the Powell trade is possible. This is where markets price in a more delayed tightening, meaning more later on. Looking farther out on the curve, the spread between the December ‘23 and December ‘24 eurodollar futures in forecasting less than two tightenings in 2024. The FOMC has a longer term, equilibrium rate of 2.5%, although eurodollar futures don’t forecast we’ll reach this level within even five years.

Markets expect the Fed to start tightening by 2023. It seems implausible that, once in motion, the Fed will move less than at least once per year. The Dec ‘23/Dec ‘24 spread has narrowed almost 25bps from its widest levels, mostly because the Dec ‘23 has moved farther from the FOMC. The Powell trade would be to buy this contract and sell Dec ‘24, betting on delayed tightening but ultimately two or more annually. At 43, it’s not yet a compelling opportunity but is worth watching in case it narrows a little more.

Eurodollar futures currently offer a rich source of information, and the occasional trading opportunity, by comparing market forecasts with those of the FOMC.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.