Friday, September 19, 2014
EDZ5-EDZ6; Not Ready to Price Steep Policy Ascent
The spread between EDZ5 and EDZ6 jumped from a Sep 5 low of less than 100 bps to 116 bps yesterday, the widest since May. Last night’s overnight high, also at 116, created a ‘tweezers top’. A seller emerged last night, selling 20,000 from 115 to 113.5 and the spread now trades 114.
This spread spiked higher on release of the Fed’s ‘dot plot’ when the yield guesses by FOMC participants jumped for year-end 2015 and 2016. Specifically, the median forecasts for 2015 and 2016 were 1.38% and 2.88% respectively. That compares to 1.25% for 2015 and 2.50% for 2016 expressed in June. The year-end ’15-’16 spread Fed guess therefore went from 125 to 150 bps or 25 bps wider. This steepening was not captured in the EDZ5-EDZ6 spread. Since the June FOMC meeting, when the EDZ5-EDZ6 spread made its previous high at 113, the spread is largely unchanged.
The Fed meets 8 times a year. Those looking for a policy rate lift-off date by Q4 2015 and pace of firming that at all exceeds 25 bps at every other FOMC meeting should be interested in owning this spread anywhere near 100 bps. Debate will continue about when the Fed will begin their policy rate firming, though the range of expectations is narrowing as the Fed continues to communicate a likely lift-off near mid-2015. The steepness of the ascent for the policy rate is largely expected to be relatively flat by comparison to prior post-easing cycles.
Capping the potential for a steep ascent is the widely expected lower longer-run equilibrium rate for real economic growth. There simply is not a lot of room for the policy rate (or Eurodollar and Fed Funds futures) to run if the longer-run potential growth rate is as low as the 2.15 mid-range forecast the Fed put out on Wednesday. If the Fed gets started on policy firming late and has to play catch-up, a steeper curve is clearly possible. Is there even sufficient time for the economy to overheat enough by late 2015 to prompt a stronger Fed reaction? The EDZ5-EDZ6 is good fighting ground for this battle. Current quote 114 114.5.