Thursday, September 1, 2016

Treasuries Not Likely to Further Price Fed; Too Risky for Payroll Short

Generally speaking, in front of the employment report, Treasury and Eurodollar future prices have a tendency to consolidate.  In particular, these interest rate futures have a tendency to revert back to early morning levels following any straying in the session(s) prior to the employment report.  Without going into great detail, this has much to do with the importance of tomorrow’s data overshadowing news and events of today. 

As such, it may be found helpful if we briefly examine current conditions and postulate what may happen for the balance of the session (10:30 cst currently) based on influences which have been brought to bear on fixed income over the last weeks. 

There has been a growing acceptance, though clearly not universal, that the employment report tomorrow is extremely important in shaping the likelihood for a Fed policy response at the September FOMC meeting.  We offered comment over the last month that highlighted reason for believing economic agents would more fully price the odds for a policy rate hike at the September meeting, starting with the examination of the July FOMC Minutes (‘FOMC Minutes ReThink’ (*1)  ).  At that time, the fed funds market had only priced a 4% chance for a September rate hike.  This morning, the odds priced had increased to over 40%, which is consistent with my most recent view given the chatter from message Yellen offered in her Jackson Hole speech and other (Dudley/Williams/Fischer/Evans) Fed official’s rhetoric. 

Given what has been priced over the last month and noting the weakness of this morning’s disappointing  ISM Manufacturing report, I suspect that the Treasury and Eurodollar futures gains from this morning won’t be so easily relinquished by the close. 

Finally, I would caution those who would look for an outsized reaction to a stronger than expected employment report tomorrow.  My research indicates that very little was provided the short who held positions through the ‘payroll’ session this year even when the report showed stronger than expected results.  For instance, this year in 5 of the 8 employment reports where non-farm payrolls beat expectations (average 66K), the benefit from holding the rolling 6th ED contract (currently EDZ7) through the report and until the end of the session was only 1 basis point; hardly the rewards someone might expect. 

In brief, since shortly after the July FOMC minutes were released (August 17th), U.S. fixed income has materially marked up the chances for a policy response.  The likelihood for even greater odds for a rate hike priced has diminished, in part because of the information in the release of the August ISM Manufacturing report and in part simply because so much has already been priced.  Prospects do not rely as heavily on the employment report now as they might have before the ISM, but the benefit from assuming the risk of that employment report is not as compelling for the holder of short positions in Treasury and Eurodollar future.  As such, it is less likely we will see a significant reverse of Treasury and Eurodollar future gains made this morning and the risk is weighted toward still further gains as short position holders remove themselves to the sidelines.    

*1 From: MARTIN MCGUIRE (TJM INSTITUTIONAL SE) At: 08/18/16 16:17:44
Subject: FOMC Minutes ReThink
It may not have been coincidental that the July FOMC minutes released yesterday afternoon began with a discussion by the Fed Staff on ‘Long-Run Monetary Policy Implementation Framework’. Although this has been a topic receiving extensive discussion within the Fed over the last year or so as conditions evolved to suggest a change in the ways in which domestic monetary policy might best be administered, the timing of this ‘open discussion’ deserves added attention. Of course, Fed Chair Yellen addresses the gathering at the upcoming Kansas City Federal Reserve Bank, Jackson Hole Symposium on "Designing Resilient Monetary Policy Frameworks for the Future" next week. She is likely to take with her some of that which was learned from her staff’s discussion.

While the Minutes did not say that the current policy rate (fed funds) might be jettisoned for something else, possibly the overnight bank funding rate (OBFR), there could be some remarks therein made at Jackson Hole. Otherwise, meeting Minutes indicated; ‘In the discussion that followed the staff presentations, policymakers agreed that decisions regarding an appropriate long-run implementation framework would not be necessary for some time.’ As such, Yellen may instead soft-step the topic by running through a list of market and funding influences which has directed the Fed’s attention.

The July FOMC Minutes were particularly interesting for a number of reasons. I believe there was information provided in the Minutes that was not more widely understood or appreciated. More importantly for those who might shift the focus of their portfolio based in part on Fed communication, I would like to briefly outline some of the thing seen within the Minutes that caught my attention.

(*1) There appeared to be an interesting difference in perspective on inflation between the Staff and Participants. In the ‘Staff Review of the Economic Situation’ there seemed to be a slightly more upbeat or constructive view on the progress for inflation returning to the 2% target as indicated in the language chosen to describe the recent change in the Michigan survey of longer-run inflation expectations. The Staff described change as follows; ‘The Michigan survey measure of longer-run inflation expectations edged up in June and was unchanged in early July.’

Participants instead noted; ‘Longer-run inflation expectations, as reported in the Michigan survey, were little changed in June and early July.’ Again later in the Minutes Participants indicate no attention to improvement; ‘Several viewed the risks to their inflation forecasts as weighted to the downside, particularly in light of the still-low level of measures of longer-run inflation expectations and inflation compensation and the likelihood that disinflationary pressures from abroad would persist.’
a. I have italicized the difference in wording and would suggest that the Michigan survey measure of longer-run inflation expectations should be afforded a greater amount of attention going forward because there appear to be room there for some important revisions in how either the Staff or the Participants view inflation prospects evolving.
2. Another very important topic that generated considerable discussion in the Minutes was the response to the UK ‘leave’ vote. I had given some feedback on that matter during the evolution of Brexit from prior to the vote through the greater digestion of the ramifications for this change. In short, I noted that the market had beforehand more than priced the likelihood for a ‘stay’ vote and following the ‘leave’ vote had reacted as if it had seen a ‘Black Swan’ (Move Along Folks – No Black Swan Here).

Within the ‘Participants’ Views on Current Conditions and the Economic Outlook’ there was a discussion of the unfolding of the market reaction to the Brexit vote. The Minutes indicated; ‘The vote by the United Kingdom to leave the EU led to sharp declines in risk asset prices and a spike in volatility in financial markets early in the intermeeting period. But those price moves were subsequently reversed, likely in response to expectations for policy actions by some major central banks, the resolution of some of the political uncertainty in the United Kingdom, and better-than-expected data on U.S. economic activity.’
a. The notion that economic agents woke-up to the possibility that ‘some major central banks’ might provide liquidity in order to short up the extraordinary post Brexit move seems a little farfetched. Rather, I suspect that ill-positioning and wrong-footed reaction to a situation that had much less immediate ramifications than apparently priced were the drivers of the over-reaction.
b. The Fed and other Central Banks (CB’s) can take some solace from the ‘backing off of the ledge’ as it does offer some insight into a more common perception that global financial market conditions are not so fragile as to allow the Brexit vote to completely unravel the financial system. This is not to say that CB’s should congratulate themselves for a fine job of communication; ‘Financial markets and institutions were generally resilient in the aftermath of the vote, apparently reflecting in part advance preparations by key market participants and communications from advanced-economy central banks before and after the vote that they would take the steps necessary to provide liquidity to support the orderly functioning of markets.’ Instead, CB’s should take a look more closely at market reaction to survey projections and betting parlor markets for these types of events as they appear to have had some strong influence on some of the positioning in front of the vote.
3. It seems that more recently the Beige Book and the FOMC Meeting Minutes have begun to meld into similar format. The Beige Book, in addition to providing anecdotal information about current conditions has started to provide bits of data that could or is possibly intended to sway public sentiment. Likewise, the July FOMC Meeting Minutes have a number of anecdotal reports:
a. ‘Moreover, several participants noted positive reports on residential construction activity from business contacts in their Districts, with a few suggesting that shortages of lots and skilled labor, rather than low demand, might be contributing to the recent slowing.’
b. ‘Several participants commented on favorable reports from their business contacts on commercial construction. Based on conversations with their contacts, participants discussed a number of factors that may have been contributing to businesses' cautious approach to investment spending, including concern about the likelihood of an extended period of slow economic growth, both in the United States and abroad; narrowing profit margins; and uncertainty about prospects for government policies.’
c. ‘In their discussion of business conditions in their Districts, many participants reported that their contacts anticipated that the U.K. referendum would have little effect on their businesses.’
i. While I see no real harm in offering out anecdotal information in the Minutes format, I might note that all three of the above offer a sense of ‘all is well’ or getting better. And maybe it is just that way – that everyone our FOMC Participants talk to is upbeat or has constructive news to report.
4. ‘Al¬though the expected path of the federal funds rate implied by market prices was about unchanged on net, the Open Market Desk's Survey of Primary Dealers and Survey of Market Participants indicated that the median responses for the most likely path of the federal funds rate over coming quarters had declined.’
a. Everything that has happened since the June FOMC meeting and the market price for the policy path is roughly unchanged. Well it was a pretty dramatic adjustment following the June SEP and interesting that despite the ‘Dealer Survey’ showing a slightly lower policy path expected over the coming quarters, the market had not gone all the way there…yet.
5. The Fed Staff indicated a number of times that conditions indicated financial conditions were ‘accommodative’:
a. ‘Domestic financial conditions remained accommodative over the intermeeting period. Equity price indexes increased, on net, despite an initial sharp decline following the Brexit vote, and corporate bond spreads declined on balance. Conditions in business and consumer credit markets were about unchanged.’
b. ‘Overall financing conditions for nonfinancial firms remained accommodative.’
c. ‘Financing conditions for commercial real estate (CRE) stayed fairly accommodative, on balance, and bank lending in all major CRE categories was strong through June.’
d. ‘Financing conditions in the residential mortgage market became more accommodative, on balance, since the June FOMC meeting. Interest rates on 30-year fixed-rate mortgages decreased further, partly reflecting the declines in yields on Treasury securities.’
e. ‘Financing conditions in consumer credit markets were little changed and remained largely accommodative against a backdrop of stable credit performance across debt categories.’
i. The Staff appears to believe there is a rather accommodative policy in place. As much as this may be the intent of the FOMC, the Staff also noted; ‘Federal Reserve communications released in conjunction with the June FOMC meeting were interpreted by market participants as more accommodative than expected.’ Given that as indicated above, the policy path had changed little since June, the policy path that is currently priced may be a little lower than what the Staff had expected to prevail.
ii. Combine this with the modestly more constructive view expressed on inflation held by the Staff relative to Participants, and we can wonder again which ‘side’ moves toward the others view.
6. In the discussion of ‘Committee Policy Action’, I thought one paragraph painted a rather more bearish leaning than economic agents more generally seemed willing to price; ‘After assessing the outlook for economic activity, the labor market, and inflation, as well as the risks around that outlook, members decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent at this meeting. Members generally agreed that, before taking another step in removing monetary accommodation, it was prudent to accumulate more data in order to gauge the underlying momentum in the labor market and economic activity. A couple of members preferred also to wait for more evidence that inflation would rise to 2 percent on a sustained basis. Some other members anticipated that economic conditions would soon warrant taking another step in removing policy accommodation. One member preferred to raise the target range for the federal funds rate at the current meeting, citing the easing of financial conditions since the U.K. referendum, the return to trend economic growth, solid job growth, and inflation moving toward 2 percent.’
a. Within that paragraph is italicized a sentence that to me indicates where we should concentrate some attention in order to learn how the Fed may react. Clearly it is employment that will be looked by the Fed for information concerning momentum in economic growth and prospects for still recovering inflation.
I’ll finish by saying that I do not necessarily see any strong chance for the Fed to raise policy rates at the September meeting. I would put those odds however toward 30%, up from 25% because of what I see in the July FOMC Minutes. There will need to be continued strong employment growth shown for July along with some additional wage pressures for the prospects for Fed firming policy in September to rise further. Additionally, any marked increase in the Michigan longer-run inflation expectations will go a long way toward increasing the chances for a September hike if employment falls in line with recent growth.
Let’s also keep an ear toward the Jackson Hole confab. Chair Yellen avoided last year, not wanting to exacerbate an already heavily regarded notion that Jackson Hole was a primary policy change launching pad. Yellen may now feel she has a freer hand in creating expectations at the Symposium.
Feel free to reach out with any questions you might have.
Martin McGuire
Managing Director – Market Strategy/Client Positioning
TJM Investments LLC; TJM Institutional Services LLC
312 432 4722

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