Monetary Policy Isn’t an Exact Science

There’s an old Saturday Night Live skit with starring Steve Martin, where he plays the medieval barber Theodoric of York, when barbers also had the role of doctor.  Yes, I know it’s a dated analogy, but I sometimes wonder whether or not the Federal Reserve and other Central Bankers are trapped in the same role:

Theodoric of York: Well, I'll do everything humanly possible. Unfortunately, we barbers aren't gods. You know, medicine is not an exact science, but we are learning all the time. Why, just fifty years ago, they thought a disease like your daughter's was caused by demonic possession or witchcraft. But nowadays we know that Isabelle is suffering from an imbalance of bodily humors, perhaps caused by a toad or a small dwarf living in her stomach.

Bernanke, in his last Brookings Institution post has the following quote:  “…there are signs that monetary policy in the United States and other industrial countries is reaching its limits, which makes it even more important that the collective response to a slowdown involve other policies—particularly fiscal policy.”   An article in the WSJ from March 17 has this line: “There is a rising concern that central banks are testing the limits of their policies,” said Brian Daingerfield, a currency strategist at RBS Securities. And today the Chicago Fed’s Evans said that challenging conditions aren’t always amenable to monetary policy solutions.  Yet global central banks continue to push on a monetary string with negative rates and enhanced QE. While the Fed diverged from other central banks and tightened in December, at last week’s March FOMC Yellen sounded a more dovish note. 

The infamous Fed dots came closer to market levels, with the 2016 median dot at 0.875 bps and the 2017 median level of 1.875.  So the 2016 dot reflects two hikes this year, followed by four more in 2017.  However, there is still a fairly large gap between the dots and the market. EDZ’16 (December 16 euro$) closed Tuesday at 9904.5 (which is consistent with FF around 75 bps) and EDZ’17 closed 9875.0.  The difference in the Fed dots between the end of 2016 and end of 2017 is 100 bps, but as you can see it’s only 29.5 as priced in the market.  However, core inflation levels in the US have started to firm up, and market based measures of inflation have also turned.  For example, the spread between the ten year treasury yield and the inflation indexed ten year note (a proxy for long term inflation expectations) hit a low of 120 bps in mid-February, but has rallied nearly ½% since then to close yesterday at 163 bps. 

The Fed’s shift to dovishness just as the inflation tide seems to be turning should be a catalyst for a steeper curve, as inflation expectations are more heavily priced along the back end.  My favored strategy to capture this idea is to go even further out on the curve:  Buy ED Sept’18 contract and sell Sept’20 contract.  The two settled at 98.545 and 98.060, a spread of 48.5 bps.  My initial target is 61 bps, around the halfway back level of the previous year’s range.  I would exit the position on a close below 42.5. 

Theodoric of York: Well, you'll a lot better after a good bleeding.

Alex Manzara



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