Interesting commentary this morning from an institutional research shop:
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Policymakers in both Europe and the U.S. have begun to hedge against the risk of a stronger economic performance in the second half of the year, and as policymakers have hedged, traders have scrambled to adjust. You get a much clearer sense for the market’s expectations for Fed policy by looking at the super-liquid Eurodollar futures market than by watching, say, the stock market or even the short end of the Treasury curve (although the 2-year yield isn’t a bad proxy). Below I’ve pasted charts which show Eurodollar calendar spreads which approximate rate hike expectations for the second half of this year (left chart) and for 2012 (right chart) over the last two years. As you can see, traders have become more hawkish in recent days.
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click for larger graphs
Eurodollar futures aren’t a perfect proxy for hike expectations because as unsecured, wholesale loans between banks, they are not risk-free like Fed Funds are. However, they are extremely liquid and at the moment there isn’t any interbank risk premium anyway (this is what is meant by “accommodative financial conditions”). So, they’re a good enough indicator for our purposes.
Here’s what’s going on with these charts:
1. Expectations for a Greenspan-esque, stair step hiking pattern prevailed up until the European crisis struck in the spring of 2010 (witness 75 basis points in hikes expected in 2H11 and another ~125 bps expected in 2012). Recall that at that time – March and April of 2010 – the Fed was defending its ability to exit from its stimulus measures. Hike expectations were all the rage.
2. The European crisis erased all hope amongst traders for a rate hike in 2H11, and by the time the Fed announced QE2 on November 4th of last year only 40 basis points worth of hikes was priced in for 2012 (this loss of hope is represented by the downward-sloping portion of both charts). The stock market was on fire in September and October but traders of Eurodollar futures were dovish throughout.
3. Following the QE2 announcement (and Bernanke’s op-ed in the Washington Post the day after the announcement), expectations for more hawkish policy began to rise again and by early-mid February of this year traders were pricing in nearly 150 basis points in hikes by the end of 2012 (this is the pronounced spike on the right hand side of the chart on the right). Confidence in the economy was growing, but that was only part of the story. Commodity prices were on a rampage (punctuated by the riots in MENA) and all of a sudden it looked very unlikely that the Fed would be able to maintain ZIRP for two full years.
4. THIS NEXT BIT IS IMPORTANT: traders began to reduce their bets on more hawkish policy before the Japanese earthquake struck on the morning of March 11th (only 120 basis points of hikes for 2012 were priced in, down from 144 just three weeks earlier). Of course, when the earthquake hit and nuclear disaster loomed in Fukushima the bets came off even quicker. “The Fed can’t raise rates if this Japan situation destabilizes the global economy” was a common refrain. Traders reduced hawkish bets until just 100 basis points worth of hikes were priced in for 2012.
5. When the acute risk of a meltdown was averted, the risk trade was put back on with gusto. Bullish comments from Larry Fink a week ago today (equities are “very cheap versus credit spreads”) had CNBC pundits wondering aloud whether this would come to be known as “the Fink rally” – just as the September-October 2010 rally was known as the Tepper rally. The one hundred basis points of expected rate hikes by the end of 2012 swiftly became 125 basis points.
6. In recent days, the always-hawkish Fisher, Plosser and Hoenig were joined by Bullard and – just a few minutes ago – Kocherlakota in peppering the tape with hawkish rhetoric. Rosengren and Evans did their best to make their dovish voices heard, but the hawks have drowned them out. From the open of the New York Stock Exchange to the close today, expectations for rate hikes jumped 10 basis points to 138 bps.
Meanwhile, the ECB is poised to raise its minimum bid rate to 1.25% from 1.00% next week, effectively separating its interest rate policy from its liquidity policy – something which the Fed has said that it too can accomplish now that it has the power to pay interest on reserves. Bank of England Governor Mervyn King is also under pressure to address rising inflation, and the upshot of it all is that the hawks have gained the upper hand.
Maybe it’s because I saw the man behind the curtain in 2008 and 2009, but I just can’t take any of this “strategy” seriously. The Fed right now is like a player – as in, “don’t hate the player, hate the game” type of player. The market is the one being seduced. Easy monetary policy is – you guessed it – the booze. Does the seduced party care about or even remember what the player says over drinks? The cheesy lines, the forced confidence – the player thinks these things matter but the seduced party has already made up their mind. As long as the player doesn’t screw up massively and keeps the drinks coming, the night is going to go well.
It’s the same with the Fed and the market. I’ll spare you the detailed explanation since I’m pretty sure you can figure it out on your own. Suffice it to say that we’re at that stage of the night where the player feigns concern over how much the seduced party has had to drink. It’s all part of an age-old script but the lines themselves do not matter. Meanwhile, I’m sitting at the other table, drinking a cranberry juice and watching the whole thing go down.
Play on, player – as the kids say. I see no signs that this odd bull market can’t continue (see my March 28th Uptick for my reasoning). The margin of error separating Europe from a liquidity crunch and debt deflation narrowed again this morning thanks to the news flow out of Ireland and Portugal, and the U.S. consumer remains on life support, but promises have been made to markets and I see no sign of a breach of contract. If the markets can produce new highs in the coming weeks, the economy will lurch forward as well, burdened though it is with debt. Those betting on rate hikes will prosper until chaos strikes (who knows what form it will take) and reveals the vulnerabilities of this new system.
