Well, interest rates got interesting fast after I posted my update Wednesday. Here are updated versions of a couple of the graphs.
The market reaction seemed overblown compared to the information contained in the economic data that was released Wednesday. I have been pleasantly surprised by the reaction from FOMC officials that suggests they are willing to loosen up, at least a little bit. I'm not sure if it will be enough to make much difference.
In the meantime, labor markets continue to look strong. So, I think we might still be looking at a situation of weak signs in financial markets but a strong economy in terms of production and employment.
I think this is a speculator's market. These are the kind of situations I look for in individual equities, like in my current favorite Hutchinson Technologies. The ability of markets to provide stable and efficient prices breaks down when the distribution of possible outcomes deviates from normal behavior. For some time, prospects for HTCH on a 5 to 10 year horizon have been such that they are likely to be worth very little or something more than $10. They have been trading in the $2 to $5 range. The distribution of outcomes is kind of an upside-down normal curve. It is highly unlikely that HTCH will be trading at $3 in 5 years. This kind of situation causes the expected cash flows of the marginal investor to take a back seat to other issues, like reputation, fear of losses, etc. Expected monetary returns can be very high, and returns to unobservable stock picking skills become very high.
We have a similar situation now in the broader market. It has been that way for some time. Under QE, investors were split between high inflation expectations and worries about perma-QE at the zero lower bound. I think the decline in the TIPS spread in 2013 might have reflected a reduced variance in expected inflation more than a reduced mean expectation for inflation. In fact, that was the subject of my very first post on this blog, and a couple of follow ups.
After the rate increases in mid 2013, through most of 2014, I had a slightly bullish position on rates (short bonds) that I traded as a synthetic short option. (I traded so that I gained from mean reverting volatility). That is because I forecasted a positive labor market for 2014. I predicted that, on net, the distribution of possible outcomes in the near future would become less variable. This is because the taper of QE3 would quell fears about inflation while the strengthening labor market would quell fears about deflation. I expected housing to eventually recover more strongly than others seemed to expect, which would eventually bias markets even more away from deflation worries. In the meantime, I traded the transitory volatility in the day to day markets.
I think we have mainly gotten to the place I expected us to. Except, housing credit markets haven't seemed to recover enough to pull home prices up to levels that would re-establish a sustainable housing credit market. So, I have retracted my bullish position on real estate and home building for now, and my bullish position on interest rates (bearish on bonds). And, the volatility dynamics are now reversed. Instead of reverting to the mean with declining volatility, the end result for interest rates is now probably a two-tailed monster. Much like with HTCH above, the odds that June 2017 Eurodollar contracts will expire at 2% are very low. But, the problem is we don't know if they will expire at 0.1% or at more than 3%, and much of the outcome depends on coming arbitrary Fed decisions. So, a directional speculative position will eventually pay off very well here. But, which direction is anyone's guess. The trick now will be to take a position on that direction before the market fully prices it in.
In the meantime, this tipping-point context might mean that seemingly small pieces of information in one direction or the other could create large swings in market prices.
That said, looking at the forward Eurodollar curve, this recent move doesn't look as pessimistic as it first did. With such a large decline in equities, it seemed like the market reaction was a reaction to more possible demand shocks. But, especially after recovering a little, the change in rates looks like it has come mostly from an expected delay in rising rates, which could reflect some pessimism about near-term markets, but this pessimism appears to be paired with an expectation of a counter-effect of appropriately looser monetary policy. The end result of the last three days' interest rate moves has been a move back in time of about 1 month in the first rate hike and a slightly slower expected rate of rate increases after that. The expected date of the first rate hike had already begun moving back earlier in the month, so that, as a whole, since early October, the expected date of the first hike has moved from about June 2015 to about September 2015, according to my model. I think that's a lot smaller change than some observers realize.
As we move out on the yield curve, forward rates had collapsed since the beginning of the year, from more than 5% to about 3.5%, and the last leg of that collapse had come in early October, along with collapsing inflation expectations. But, with the rate drops this week, the forward rates at the long end of the curve actually held their own.
I suspect that the long end of the curve is partly a comment on the odds of being stuck at the zero lower bound. Long term rates have shrunk by about a third, and the slope of the curve during the rate hike phase (2015-2018) has also dropped by about a third (from about 34 to about 23 bps per quarter). This could represent a bifurcated expected outcome distribution, with a 2/3 chance of seeing rates increasing at more than 1% per year starting sometime around 2015-2016 and topping out at around 5%, and a 1/3 chance of never leaving zero. (The slope still seems a little low, which I attribute to a weak housing credit market.) Anyway, if this is a true reflection of market expectations, then the flip out this week may not have reflected any increase in the odds of staying at zero.
All in all, I would say that this week's move signals some confidence in forward monetary policy. Let's hope that's true.