It’s Time to Short the Front End

Fed credibility is really being challenged by the market. I know lots of people say the Fed has already lost credibility, etc. But I never really believed that because the Fed has only every tried to explicitly control the front end of the curve. This is the first time in a long while that the market has stopped paying attention even to that. Here is what we learned from the Fed the past couple weeks:

Esther George voted for a hike in July. In the minutes, she listed one reason for her dissent was that

· “She believed that by waiting longer to adjust the policy stance and deviating from the appropriate path to policy normalization, the Committee risked eroding the credibility of its policy communications.”

Dudley, the vice chair of the FOMC and clearly part of the leadership noted not once, but twice that market pricing of Fed policy was too dovish:

· 8/16: 10y treasury yield is pretty low given circumstances

· Bond market looks a bit stretched to me

· Market is complacent about need to gradually hike rates

· Fed Funds futures market is underpricing rate hikes

· 7/31: policy will likely need to move faster than market expects

· Market view of only one hike through 2017 ‘too complacent’

And now Fischer, the vice chair of the board, noted that:

· core PCE inflation, at 1.6 percent, is within hailing distance of 2 percent–and the core consumer price index inflation rate is currently above 2 percent

· So we are close to our targets. Not only that, the behavior of employment has been remarkably resilient.

· Employment has continued to increase, and the unemployment rate is currently close to most estimates of the natural rate.

So this means that we have one openly dissenting voter and 2 of the top 3 FOMC officials tilting toward a hike. Yet hike expectations have remained minimal. Fed Funds pricing in less than 1 hike in the next 12 months, and just one hike through Dec 2017.

Yellen is up next. It is unlikely that her views are completely opposite that of her colleagues. And she might not feel compelled to comment on near term policy on Friday. But the dichotomy between Fedspeak and market pricing is something she is clearly monitoring.

To be fair, there are a number of potential explanations for this dichotomy. They include:

1. Throughout all this, the Fed has also been talking about a lower r*. IMO, there is a very big difference between hiking a few times and a terminal rate below 3%. Both can and is likely to be true. But the market seems to only believe the latter half. It’s probable that the mental/algorithmic framework of market investors/algos tend to see Fed policy in one dimension – either dovish or hawkish.

2. There has been a substantial drag on growth from financial conditions over the past year, hitting just when the Fed first hiked. We can see that based on the dichotomy between Fed forecasts last Dec vs what has actually transpired. That effect has reversed by now, however, while market pricing has not.

3. Many participants seem to believe that the Fed will not want to risk affecting the election and moving in Sept, so the next probably date is Dec. Since we are still 4 months from the December meeting, there is probably still a fair bit of complacency

4. The bull trend in bond prices has been very strong, and long, and it does not seem threatened, at least not yet.

The market pushback against Fedspeak would be normal if the data was disappointing to the downside. But the opposite is true. As others have noted, the Bloomberg US economic surprise index has turned positive for the first time since December 2014, (That corroborates point 2 above, IMO) and are not far from levels that prevailed ahead of the Taper Tantrum in early 2013.

This is further corroborated by the fact that the industrials sector of the US stock market has broken higher. The last time that happened was also a couple months before the Taper Tantrum:

In sum, with downside limited, Fed speak hawkish and the fundamentals turning, the risk reward for shorts at the front end now seem very attractive.

I’m anticipating a few questions here about whether a more hawkish Fed will be bad for equities. On the contrary, I think it is still a good time to be long equities. IMO, the Fedspeak about a lower r* further supports the view that lower long term discount rates are sustainable. That is supportive for equities, because it is clearly not fully priced in.

In addition, a number of people seem to think that the ONLY reason the S&P is here is due to where yields are and/or monetary policy. Interestingly, these folks also seem to think PE multiples should be static and not move due to changes in yields. This type of contradiction is usually a sign that their model of the financial world is at least partially incorrect. By my estimates, equities remain quite cheap relative to rates products, even after adjusting for externalities, and would remain cheap even if the entire curve shifted upwards by 50bps. The valuation gap, in other words, is substantial and the worries of the investors that equities valuations are at risk if yields rise are already in the price. I continue to think equities will close out the year with a return well in the double digits.

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8 thoughts on “It’s Time to Short the Front End

  1. As much as I am simpathetic to the view, I dont see a great risk-reward to make me feel compelled to have this trade in a decent size. Fed funds 1y ahead are pricing in one full. hike. I can see at maximum two hikes, making it a 1-to-1 proposition. I think one needs to have a strong view for the September meeting in order to have this on the book.
    On the minor impact a hike would have on equities, I agree. Would be happy to see your valuation. I think equities gaining double digits is the most contentious view on your post.
    Cheers, FMD

  2. Japanese flow into foreign fixed income 15 trillion jpy since neg rates, aren’t EU / Japan the whale?

  3. Nice post & Interesting thoughts. I agree with FMD that risk reward isnt very skewed but that still doesnt mean it isnt worth a punt in EDZ7 like you said. Not sure how much they would rally if she didnt hint at anything but I am guessing its probably a lot less than they can sell off (2:1 just by looking at the chart for s/r points

    I agree with pointing out the logical flaw of saying equities are only here bc of low rates. If that were true, then whats up with EU and JP equities, which should be at the moon

    1. Thanks.
      Here’s another point of view in support of sustainable faster hikes. Even with a zero r*, that’s 2% nominal. Even if it does take 2.4 years for core PCE to get to 2% and the Fed to get to zero r*, that is another 7 hikes from here. So that’s ~3 hikes per year. And that doesn’t take into account the facts that 1) inflation is clearly bouncing 2) slack is much smaller now than at any time since the recession 3) a stable oil price is likely to provide at least some further support 4) economic momentum is picking up 5) asset prices are getting richer. So I think the risk reward is quite a bit better.

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