Last week I mentioned that the very short end of the market, i.e. near Eurodollar contracts, were priced for the Fed to hike today. In the grand scheme of things, a 25 bp move isn’t all that important, if considered in isolation. It’s not as if all rates across the curve and products instantly rise by ¼%. For example, the US ten year treasury has had a range of 85 bps this year without a change in the Fed fund target. Last week I noted that the peak one-year Eurodollar calendar spread, March’16 to March’17 was around 5/8% or 62.5 bps. On Tuesday this spread settled 62.0, consistent with the idea of 2 to 3 hikes over a year.
The important aspect of today’s FOMC is the trajectory and speed of future hikes. As has been noted by the financial press, several foreign central banks have hiked since the crisis in 2008/09, only to have reduced rates again, for example Bank of Canada. The entire structure of the market is priced according to the idea of steady rate hikes. I just want to highlight an alternative scenario, one that the market doesn’t ascribe large odds to, but which I think could easily unfold over the next two quarters.
Let’s say the Fed hikes by 25 bps, but warns that future hikes are data dependent, and even notes a specific inflation target that needs to be met before additional rate increases. Further imagine that Yellen puts a bit more emphasis on risks from overseas. The forward interest rate market may scale back the pace of prospective rate hikes. One of the factors underpinning USD strength has been expectation of steady rate hikes. With recent skittishness in stocks, the dollar has lost some ground. What happens if the dollar trend shifts bearishly due to revised perceptions? For one thing, a weaker dollar would probably boost commodity prices, which have been under severe pressure. There has been a recent trend toward curve flatteners, these could begin to unwind violently. If the dollar weakens and the curve steepens, some of the flows that have accrued to US equities could also reverse. In other words, US markets could see both stocks and bonds weaken at the same time, while commodities firm up. Would this scenario help inflation actually perk up? Perhaps, but the depreciation of the Chinese yuan against the dollar in the past two months is a reminder that some of our dis-inflation is imported. New lows recently posted in the Mexican Peso also send the same reminder.
How likely is such a scenario, and what are the odds that a massive unwind of positions occurs? I would say they’re about 25%. Just remember, sometimes the markets want to inflict the most pain possible, something that junk bond investors have recently gotten a taste of. It’s best to keep an open mind to the possibility of untoward events, and adjust your risk tolerance accordingly.
Alex Manzara: www.chartpoint.com
