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.

Fed chair Jay Powell appeared slightly less confident at Wednesday’s press conference. He acknowledged that their forecast of temporarily higher inflation might be wrong, and it was hard to say when it would moderate. He repeated his warning that, “forecasters have much to be humble about.”

This humility must apply to the Fed. One of the most striking updates in the Summary of Economic Projections was the FOMC’s upward revision to 2021 inflation, from 2% in March to 3% now. In his March press conference, Powell spoke about upward price pressures over the near term but assured there would be only “transient effects on inflation.”

Clearly FOMC members were surprised by the inflation reports since then, hence the sharp upward revision. They’re not good at forecasting — certainly no better than a below average private economist. But FOMC forecasts matter because monetary policy and the ongoing debt monetization are managed with reference to those forecasts of moderating inflation.

Powell often downplays the dot plots even while the media examines them in detail for comparison with interest rate futures. Seven out of 18 FOMC members expect at least one rate hike next year, up from four in March. The median of their 2023 forecasts is for two hikes, up from zero in March. Interestingly, the forecast ranges for inflation (2.0-2.2%) and unemployment (3.2-3.8%) for 2023 are both unchanged. Taken together, it looks as if the FOMC is slightly less comfortable with waiting for full employment before lift-off.

Prices for 2023 eurodollar futures adjusted down following the press conference, and now more closely reflect this new interest rate forecast.  Three month Libor currently sits within the policy rate range, but when the Fed starts raising rates money market rates will probably build in a positive spread. The risk remains asymmetric but following last week’s jump in yields the compelling risk/return on shorting has gone.

If the FOMC’s more hawkish rate outlook with an unchanged economic outlook means they’re embracing a modicum of humility, this is a positive development. It means the long overdue ending of the $120BN in monthly bond purchases is within sight.

Inflation is far from a purely US problem. Central banks in Russia, Turkey and Brazil have all raised rates in recent weeks. Norway’s central bank expects to raise rates by 1% over the next year. The UK is experiencing higher than expected inflation, and is engaged in a similar debate about how transitory it’s likely to be.

The irony is that the US is dropping most Covid restrictions earlier than almost any other country, has the most accommodative monetary and fiscal policy and the fastest GDP growth.  Jay Powell referenced inflation 16 times in his prepared remarks and employment 15 times, a carefully calibrated balance that was probably no accident. He still sounded quite dovish, prioritizing getting everyone who wants a job into one over keeping inflation at 2%. He believes inflation expectations remain, “broadly consistent with our longer-run inflation goal of 2%.”

But the forecast of earlier tightening embedded in the dot plot shored up Powell’s message. Inflation expectations, which had modestly declined over the past month, fell another 4bps. On Friday, Federal Reserve Bank of St. Louis President James Bullard said inflation was stronger than anticipated. I suspect Fed chair Powell is more dovish than the median on the FOMC.

We’ve noticed that eurodollar futures and inflation-sensitive stocks such as the energy sector have developed a changed relationship. This year yields rose with commodities, pulling pipelines along with them. But the positive correlation between interest rates and energy is showing signs of evolving into a more complimentary relationship. Over the past month prior to Wednesday, pipeline stocks rallied strongly at the same time as eurodollar yields fell, reflecting declining expectations of 2023 tightening. Following Powell’s press conference eurodollar yields moved sharply higher. James Bullard gave them a further push on Friday. The market is adjusting to a slightly more hawkish Fed and consequently moderating inflation fears. Commodities and energy fell as a result.

The Fed’s posture of extreme monetary stimulus synchronized with profligate fiscal support raised inflation fears. A step back from that has moderated such concerns. It may be that rates and energy will adopt more of a yin and yang relationship, although in our view both are likely to be higher a year from now.

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

This past winter included some tumultuous weather events with implications for global energy markets. Winter storm Uri exposed vulnerabilities in the Texas power grid, and left millions without heat during an unusually cold snap (see Why Texas Lost Power). All power sources provided less than needed – some blamed the state’s excessive reliance on windmills, many of which iced up rendering them unusable. Others note that natural gas also came up short, although it was the only energy source able to increase its output.

Texas has its own power grid (overseen by the Electricity Reliability Council Of Texas, or ERCOT) which is lightly regulated. Electricity is cheap, but providers aren’t required to guarantee 100% continuous supply. The February price spike in natural gas created a windfall gain for some pipeline companies including Energy Transfer and Kinder Morgan (see Why The Energy Transition Is Hard). It was the only source of energy able to respond to price signals.

Renewables are intermittent, working best when it’s sunny and windy. Bad weather can take all solar and wind offline simultaneously. For grid managers this is analogous to owning a portfolio of investments that provide diversification except during a big market fall, when it’s most needed. Solar panels and windmills generate power only 20-30% of the time, operating at far lower capacity than combined-cycle natural gas power plants. Reliable power means natural gas.

North east Asia also endured a surprising cold spell in January. The JKM benchmark price for Liquified Natural Gas (LNG) exceeded $20 per Million British Thermal Units (MMBTUs). US natural gas prices are remarkably stable, generally not moving too far from $3 per MMBTU.

The Asian spot LNG price rose 10% last week to $12 per MMBTU amid continued robust demand. Looking ahead to prices for January 2022, both the JKM Asian benchmark and the European TTF futures have been rising in recent months, widening the spread with the US Henry Hub benchmark. The price difference is comfortably enough to cover liquefaction, transportation and regasification of US natural gas to markets in Asia and Europe. American energy will be helping keep Asians warm this winter.

As a result, American exports of reliably cheap LNG are drawing the attention of global buyers. Tellurian (TELL) is a recent beneficiary, having signed ten-year agreements with Gunvor and Vitol to provide each with 3 million tons per annum of LNG (see Profiting From The Efforts Of Climate Extremists). These commitments have improved the odds that Tellurian will be able to finance and build the Driftwood LNG export facility in Texas.

Green energy policies are helping – TELL CEO Charif Souki has noted that European carbon taxes act as a floor on local natural gas prices by penalizing coal. TELL’s previous strategy was to sell natural gas to buyers at a price linked to the US benchmark, but foreign buyers prefer to lock in prices against their local benchmark. TELL’s recent deals have retained this spread risk for the company,

The market is taking advantage of cheap US natural gas. This helps lower emissions, both by reducing coal consumption but in some cases by providing reliable back-up for increased use of renewables. If the logic of this strategy penetrates the thinking in the Biden administration, they may start advocating for increased exports of US LNG, which could raise domestic prices.

However, building LNG export capacity is costly and time-consuming. Environmental extremists in Oregon have thrown up enough roadblocks to Pembina’s planned construction of the Jordan Cove LNG export facility that it’s unlikely to be completed. So while the arbitrage spread between US and foreign natural gas markets ought to close, physical constraints on US exports may allow it to persist for several years.

On a different note, the International Energy Agency (IEA) drew headlines last month when they published Net Zero by 2050. Director Fatih Birol said, “The pathway to net zero is narrow but still achievable. If we want to reach net zero by 2050 we do not need any more investments in new oil, gas and coal projects.” Driving up fossil fuel prices by constraining supply is a logical way to increase renewables demand, by improved relative pricing.

Last week the IEA showed how confused they are by saying that, “OPEC+ needs to open the taps to keep the world oil markets adequately supplied.” This is their recommended response to rebounding oil demand. That they are advocating for reduced long term supply but more short-term supply betrays an incoherent thought process not worth the attention they get. St. Augustine’s spirit, (“give me chastity, just not yet”) often resolves the internal conflict in switching from today’s efficient energy sources to intermittent, less efficient “green” alternatives. A more thoughtful IEA would advocate for more natural gas supply over all time frames, to reduce coal consumption and support electrification. They’re just not there yet.

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