Rate Wars – The Fed Awakens!

This week I’ll be treated to two events which excite me so much I can barely write about them cogently. Firstly, on the 17th of December, “Star Wars: The force awakens” will open for general release in the UK. Secondly, I will get to watch it! Oh and also there’s the Fed…

For those of you lucky enough to avoid daily contact with financial and economic concerns, or who live as troglodytes in abandoned underground stations shambling into an internet cafe for the first time to read my blog, the market expects the Federal Reserve of the USA to raise the Fed funds target rate for the first time in many years. Rates were lowered to 0.25% in response to the global financial crisis of 2007/8 – and after successive bouts of QE, and five years of rates at emergency level, the market has got it into it’s head that rates are going up.

It’s worth taking a moment to consider how the market got this idea. They certainly haven’t been told directly by Fed officials. Neither has the market inferred the Fed’s likely course of action from the economic data, which has not materially changed since the last meetings. Rather, market participants have interpreted statements such as this  from Fed chair Janet Yellen as implying that a hike is coming. Further to this tea leaf reading, one hears any number of non falsifiable conjectures and obvious psychological comfort mechanisms:

“They have to hike now to avoid disappointing the market” = I’m short
“They’ve always hiked when when unemployment has been less than 6% in a month with an r in it” = I don’t understand how conditionality works
“They have to hike now to avoid hiking too quickly later” – I’ve got the flattener on
etc etc

If one looks at the spread between the first and second Fed Funds futures , it’s possible to infer a market implied probability of a hike. The spread’s never quite going to be 0.25% because if it were, betting against a hike would effectively be free (ie, if they hike, you lose nothing, if they don’t you make 25. NB – Fed hikes are assumed to come in 0.25% increments). If it’s 0.2% – that implies an 80% probability – you’ll risk 0.05 to make 0.025 if you bet against a hike. No longer a free bet but given the hardly airtight case, I felt pretty confident recommending a  short term tactical long in 2y Treasuries on Friday  at approximately those odds, judging we had a weeks worth of data to get through and the odds would likely even up a bit.

2y Notes 11 Dec 15

What happened next being a prime example of how if the fundamentals line up, the ‘reason’ for a price move takes care of itself in short order – to the extent I don’t even remember what headlines it was that pushed bonds higher, stocks lower and oil lower on Friday – because it doesn’t matter.

All of that said, I do think that we’ll see a move from our friends at the Fed on the 16th. It may sound from my use of the phrase ‘tea leaf reading’ that I set no store in the analysis of Central Bankers pronouncements – but I do – ultimately the one thing people hate more than being wrong is being perceived as inconsistent. This applies to the creme de la creme central bankers as much as anyone else. If Yellen says that she fears leaving hikes until later means she’ll have to go too quickly later, delaying looks strange indeed. However, I’ve no interest in betting on the Fed funds future. If we get to even 60% chance of a hike as the decision nears, I wouldn’t bet in favour. Risk 15 to make 10? No thankyou. Rather, I’ll likely turn around my long in 2’s and go short in Green Libors (see footnote!) in the hours before the Fed decision. Why? Well, the one totally consensus view amongst those I talk to is that Yellen is going to send a dovish message on future rate hikes – in line with her previous comments. However, what markets are forgetting is just how challenging it will be to:

1. Signal dovishly enough to satisfy a market that already prices an EXTREMELY dovish message
2. Do this whilst simultaneously explaining why she didn’t hike in Sep

Number 2 is really important. Given that the data has not changed much in the previous few months, Yellen will struggle mightily to find any reason that she hiked in Dec rather than Sep – apart from that she is now interpreting the same data more… Hawkishly. That’s a pretty challenging thing to communicate whilst also telling the market to expect a very dovish path of future rate hikes. It may seem a bit wishy washy to say this, but one has to consider as well that the market does not really have confidence in Yellen – she is considered to be an ivory tower academic who does not ‘understand’ the ‘needs’ of the market. In trader talk this means ‘She don’t think like me and I don’t trust her’. If market participants don’t believe she’s playing the same game as them, they won’t register subtle messaging and focus on the changes to the statement. For me, it’s looking like a great set up to go short.

NB: Useful bit of market jargon. Interest rate futures are contracts on the price of borrowing money for 3 months in the interbank market. The dates are always the same – from the 3rd wednesday of each IMM month (Mar, Jun, Sep, Dec) to the next IMM month. That means the first contract is currently dec 15. The first four futures are called the fronts or whites – so this would be ‘ftont dec’. The second four are called the reds. The third, Greens, and so on .


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