Last week on July 27, the Federal Reserve had an FOMC meeting. No change in policy was expected, and none occurred.
Once again, let’s consider the Eurodollar calendar spreads. As a reminder, the one year calendars typically are a proxy for how much tightening may occur in a given year. At the start of the year, the nearby one-year Eurodollar calendars were around 60 – 65 bps, and recall at that time, there were expectations by analysts of 3 or 4 hikes during 2016 (none of which have yet to occur). In fact, the December 2015 ‘dot-plot’ pegged the Fed Fund target at an average of around 1.25% by the end of 2016. The current FF target range is 0.25 to 0.50%, and at most, it seems like there might be one hike in 2016. The spread between the December2016 contract and December2017 closed Tuesday at just 12.0 bps. The low in this spread has been 11.5 bps. The first four quarterly euro$ one-year calendars are all between 12 and 12.5. These levels are an indication that even throughout 2017, there might only be one hike.
On Monday, NY Fed’s William Dudley gave a speech advising caution in the pace of hiking, but also noted that the Fed considers the policy stances of other central banks. He said that “…the expected forward interest rate paths in Europe and Japan have fallen considerably this year.” And added, “…the US interest rate path has come down in tandem with the foreign interest rate paths…”
Many in the financial press have worried that central banks are losing their credibility. Certainly, given disparate views out of various Fed officials, it’s not overly surprising that the Fed’s communication policy has been the object of some criticism. But now I want to shift gears and specifically cite the jump in yields on the Japanese interest rate curve. Nowhere has government policy with respect to the economy been more in evidence than in Japan. But since July 27 (the day of the FOMC), the Japanese 5 and 10 year yields have both surged by nearly ¼%. The five year yield went from -38 bps to -16, and the ten year from -30 bps to -8. These moves are actually in reaction to the Bank of Japan’s meeting of July 28, and might be considered repudiation of the BoJ’s policies. So let’s tie these threads together. The Fed acknowledges that it considers the interest rate paths in other major economies. The markets have been testing Central Bank pronouncements on a regular basis, with the Eurodollar curve now expecting barely any hikes at all. However, longer maturity yields in Japan have jumped. Could this be a sign that yield curves across the developed world may start to steepen? If so, then fixed income may provide returns that compete much more favorably against stocks, something to take into consideration when rating the attractiveness of the equity markets.
Alex Manzara
