To paraphrase Jerome Powell—I now understand how little I know about almost everything.
I don’t feel guilty about it, the Fed has 23,000 employees1, many of them PhDs, to put the pieces together and yet we have cargo cult monetary policy.2 The Fed is hiking rates to lower inflation because historically hiking rates lowers inflation. The Fed may not know it, but this cycle is over. I don’t know how they will explain the sudden change of heart, maybe it will be obvious by the time they have to verbalize it. But the bond market is over the Fed’s nonsense. If they hike in July it will be a historic mistake.
The blue line is the Fed target rate.
The white line is the 4th euro$ minus the 2nd euro$ (currently EDM3 and EDZ2). When it’s positive, the white line is pricing hikes for the six month period, starting six months from now. A negative spread implies cuts. The market is pretty terrible at predicting hikes (chart here). But I don’t see any instances in the last 30 years where the Fed hiked after the market priced cuts in ED4/2. In March 1989 it went negative right as the Fed was about to start a 675 bps easing cycle. In September 1998 it went negative right around the LTCM troubles. September 2000 the spread went negative 3 months before the Fed started to cut. In March 2007 the market was telling a reluctant Bernanke to start easing. Again, in the first half of 2019 the spread went negative before the Fed starting cutting in response to the repo kerfuffle. Today it settled at -37.5 bps and the market is still pricing ~175 bps in hikes over the next 6 months.
The orange line is the second euro$ (ED2) on a butterfly3 against 3m LIBOR and the fourth euro$ (ED4). I’m not sure what the mathematical term is, but ED2 is doing its own thing.
Maybe if I could take the chart back to the mid ‘60s and include the pre-Volker inflation regime there would be counter examples. But IMHO, “by the pricking of my thumbs, something wicked this way comes.” It could be something out of crypto, it could be related to the Ukraine, I don’t know, but something is broken and we will discover what it is sooner rather than later.
If I’m right and the Fed is done hiking rates, EDZ2 should rally ~175 bps to ~98.10. Outright volatility is high, but there is plenty of skew to get leverage on call structures.
Something in the financial system is probably broken, but hopefully everyone can still have an amazing weekend. Happy Birthday America!
Weekend Reading
Kaliningrad update: The Germans are trying to smooth things over. Non-interventionalist takes here and here. Super helpful comments from a Lithuanian MP here.
Stop being surprised by Germany
A simple model for inflation that Jerome Powell should understand. The market monetarists, who advocate nominal GDP level targeting, who predicted the current inflation, are worth keeping up with.
Review of Richard Hanania’s book proposing that foreign policy is much better explained by special interest incentives than any ‘national interest.’
This is a translated Chinese blog post from March, that I only read recently, with some far out geopolitical takes.
This won’t matter if I am right about the market. It’s a paper from AEI making some estimates about the Fed’s current mark to market losses (-$540b as of 5/31/22, 2.85% 10yr note), the policy rate at which the Fed is cash flows negative (2.7%), and how it would be a PR nightmare.
I have quibbles with this Alphaville piece about the RRP, but I agree that RRP usage means banks don’t want and/or need all of the reserves the Fed has created and that’s deflationary.
Piece from the Office of Financial Research (which I had no idea was a thing) about the bond rout of 1958.
John Quincy Adams’ July 4, 1821 speech where he urges America to go
"not abroad in search of monsters to destroy.”
In 2021 the Fed salary and benefit expenses were $3.792B, or $165k/per employee. I’m sure many of them could earn more in private sector, but pretty good for government work. https://www.federalreserve.gov/aboutthefed/files/combinedfinstmt2021.pdf
In the South Seas there is a Cargo Cult of people. During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now. So they’ve arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he’s the controller—and they wait for the airplanes to land. They’re doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn’t work. No airplanes land. So I call these things Cargo Cult Science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.
(((100 - ED4 Comdty) + US0003M Index) / 2) - (100 - ED2 Comdty)
Very Interesting read thanks