Interesting quote from Lawrence Lindsey at last week’s Peterson Foundation Fiscal Summit: “We’re at the point of absurdity. Maybe it made sense [ZIRP] when you had a crisis. It does not make sense now. At some point what is going to happen – and this gets to my eight or nine cataclysmic number [on a scale of 1 to 10] – is that we’re going to get a series of bad numbers – a little higher inflation, higher average hourly earnings or whatever – and the market is suddenly going to say, “Oh my God, they are so far behind the curve that they will never catch up.” And the market is going to force an adjustment on the Fed that will be wrenching. That’s the cataclysmic outcome.”
Lawrence Lindsey is a former National Economic Council Director and Governor of the Federal Reserve Board. His opinions carry weight, and reflect underlying uneasiness with the Federal Reserve holding funding rates near zero in spite of an unemployment rate at 5.4%, the lowest it has been since early 2008. There is continuing dialogue about labor slack due to the low participation rate and high level of part time employment, but let’s take a look at what short term interest rate futures are telling us about the current state of both Fed policy and economic prospects.
First, three month libor has been relatively steady at about 28 bps. At the end of last year it was below ¼%, but really hasn’t moved up significantly despite the Fed preparing the market for rate “normalization.” Eurodollar futures represent three month libor rates going forward, sort of a wholesale building block of interest rates projecting into the future. The December 2015 contract settled Tuesday at 99.405, or a rate of 59.5 bps. This contract is essentially pricing in certainty of a Fed hike of 25 bps be the end of the year. If three month libor is currently 28 bps, and the Fed were to hike 25 bps before the end of the year, then three month libor would be around 53 bps. The December contract yield is just slightly higher. What about more deferred contracts?
As I have mentioned before, one year spreads give a ‘snapshot’ of where rates will be over time. If a given Eurodollar one-year calendar spread is 100 bps, or 1%, then one can roughly say that the market expects the Fed to tighten by 1% over that one year time frame. Three month Eurodollar futures trade out ten years. So what’s the maximum one year spread? It’s December 2015 versus December 2016. The two prices are 99.405 or 59.5 bps and 98.58 or 142 bps. The spread is, of course 82.5 bps. There hasn’t been a one-year Eurodollar spread above 100 bps since late last year. The tameness of the peak one year spread is an indication that the market takes Yellen at her word: rate hikes will be very gradual.
So what Is Lindsey talking about? His cataclysmic event probably relates more to inflationary signals embedded in something like the treasury two year note yield vs the ten year yield. That spread is currently 152 bps, having been as low as 120 in February and as high as 170 earlier this month. At the end of the 2004 to 2006 Fed hiking cycle, what I would call the boiling frog rate hike cycle, the 2 year to ten year spread went to zero. The Fed had raised rates in quarter point increments from 1.0% to 5.25%, but long end yields barely moved higher. The market realized that economic growth would be squeezed off and there should be little or no inflation premium.
If, and it’s a big if, the spread between two year and ten year yields significantly steepens in response to “…a little higher inflation, higher average hourly earnings or whatever” then the market will have signaled that the Fed is behind the curve. In a financially global interconnected world, it can happen quickly. That’s what Lindsey is concerned about. It’s the opposite of the boiling frog scenario, it’s touching a hot stove with instantaneous pain. The yield curve can give you clues about how hot that stove is. It’s warming up, but not yet forecasting that the Fed is too far behind the curve.
