Remember how a couple of weeks ago Federal Reserve President Neel Kashkari told the investing community he was in no hurry to raise rates?
The previous day Fed Chair Janet Yellen had spoken. At that time the markets were assigning an approximately 35%-40% chance of a Fed hike at the March meeting. Instead of guiding towards a hike, Yellen ducked, and when combined with Kashkari’s comments, the market assumed the Fed would once again err on the side of raising later rather than sooner.
But the following week the Fed’s tone changed.
Suddenly the talk became much more hawkish. Instead of using words like “likely needed,” Fed officials flat out guided towards 3 hikes. And then yesterday when Dudley (who is considered more senior and would most likely not speak without Yellen’s approval) affirmed the recent hawkish rhetoric, the markets immediately repriced the odds of a March hike to a near certainty.
There was no gradual walking up of expectations. In the final week before the blackout period, Fed officials brutally tossed the market for a loop.
I stumbled upon a terrific post in Bloomberg’s Market Wrap Live Blog from Cameron Crise that illustrates the severity of the move.
Yesterday was the largest one day change in near month Fed funds expectations since the credit crisis.
The truly amazing part is that the Federal Reserve is supposedly “data dependent” but there was no data to justify the change. Usually this sort of move occurs when there is a surprise economic release.
So what happened? Well, the reality is that the real mistake occurred when Yellen did not affirm a March hike. The market realized it was needed, and when she whiffed, some senior Wall Street strategists wrote pieces about how “the Fed should hike in March, but probably won’t.”
And here is the scary part. I think had the Fed not seen these sorts of pieces, they wouldn’t have guided towards a March hike.
In essence, the Fed only tightened once Wall Street shamed them into it.
I can’t think of any other reason why the Fed would have chosen until the last possible moment to guide expectations higher.
But the really sad part of this whole episode? The Fed was bullied into raising rates. Yup, regardless of whether it is the right move or not, they are letting Wall Street push them around.
The street is positioned with record large short positions in short term interest rate futures contracts.
With such large speculative short positions at the front end of the curve, a Federal Reserve that is slow to raise rates (falls behind the curve) is expensive. So although you might wonder why stocks and other assets are all rocketing higher today even in the face of tighter monetary policy, it’s because it has already been discounted.
The street was saved by Yellen’s Fed’s strange last minute guidance towards a March hike, but could this be a sell the rumour buy the news set up?
The 5/30 year yield spread has been hammered lower with the Fed’s relatively tight monetary policy (at least compared to most other Central Banks) and the world wide long bond chase that has kept the US 30 year bid.
260 basis points a couple of years ago all the way down to 104 bps is a large move.
Yesterday’s Dudley comments, combined with an exuberant dose of Trumphoria, pushed the spread all the way down to the recent lows.
The specs got lucky with the recent March hike guidance, but I doubt they are pushing their bets. Since this morning the 5/30 spread has rallied hard. We are already 500 basis points off the lows.
The Fed has shown they are not going to get out ahead of the curve (they are a bunch of mopes), and the yield curve is overly optimistic about the Fed’s ability to control the long end of the bond market. I want to be short long bonds, and given the crowded short positions at the front end of the curve, being long 5/30s seems like a great way to play it.
If the economy rolls over, then the curve will steepen quickly. If instead the economy takes off, the Fed will probably not raise rates as quickly as the market wants.
Thanks for reading,