Well, as many commentators and traders warned ahead of time, the dollar and yields were highly susceptible to big moves ahead of the Fed as CPI and retail sales data had the potential to upset the FOMC applecart even more than it was already upset.
The data didn’t disappoint. Well, I mean it definitely did disappoint in terms of what it conveyed about the economy, but it certainly didn’t disappoint in terms of catalyzing a big move in yields and the greenback, both of which plunged after the data came in soft.
Notably, core CPI rose 1.7% y/y, that’s down from 2.3% at the start of the year and the lowest since May 2015.
Or, summed up:
But you shouldn’t worry, because this is a face that screams “I’ve got this under control”:
So given that, you might be wondering how markets are pricing the trajectory of policy normalization and in turn, how to trade Treasurys going forward in an environment that’s rife with uncertainty not only about the economy, but about the composition of the Fed itself.
Here’s Bloomberg’s Cameron Crise with his thoughts…
Wednesday’s disappointing economic data has once again moved the needle for Fed expectations, sending Treasury yields lower. The bond market reaction looks pretty appropriate given the decline in expected Fed tightening. Given the opacity of the Fed policy trajectory, particularly into next year, it’s useful to identify a framework for fading extremes.
- The market is still pricing a June tightening as more or less a given. While there does appear to be a high likelihood of a move (given prior communications), traders can get fantastic odds for betting on a shock “hold” decision.
- However, market pricing for a hike in the second half of the year has fallen below 50% after the poor retail sales and CPI figures. Ordinarily, market pricing over the relative short term is less important than that over longer periods of time. For example, a model incorporating Fed pricing out 18 months has substantially more explanatory power (r-squared of 0.71) for changes in 10-year yields than one using Fed pricing out 6 months (r-squared of 0.29).
- Taken literally, that would suggest that 2H pricing doesn’t really matter that much. Of course, 2H and 2018 expectations and pricing are not independent variables, so taking a view on the one naturally leads to conclusions for the other.
- However, the market’s ability to forecast policy shifts in 2018 is unusually poor right now, for the simple reason that we don’t know the identity of the next chair of the FOMC. Is it any surprise that they have taken a cautious approach to pricing hikes?
- Historically, fading extremes in Fed pricing has been a useful heuristic for trading bonds. Specifically, fading rate- hike expectations below 25% or so when there is ample time for the Fed to change their mind has generally been a good idea. By the same token, so has fading expectations above 75%, as the past few weeks have demonstrated.
- Given that forecasting this year should prove “easier” given the known identity of the Fed chair, I’ll be focusing on that 2H pricing for clues as to when the odds are good to step in front of the raging bond bull — and when it’s a good time to go bear hunting.