Today is the day. Both Draghi and Yellen speak later at Jackson Hole. Although expectations for market moving news have been damped down, the market might be getting a little too complacent.
Over the past month or so, bond markets have been drifting higher on the assumption the Fed would take a dovish wait-and-see approach to the introduction of quantitative tightening (widely expected to be started in September.) On the other side of the Atlantic, investors are increasingly pricing in a slower tapering to the ECB’s quantitative easing program, believing Draghi would rather overshoot than risk pulling a Trichet by tightening and then be forced to quickly resume easing.
Have a look at the movement over the past three months of the Fed Funds futures’ curve:
The Fed Fund futures curve has not only shifted downward (in terms of yield), but also flattened with the far month contracts falling farther than the near months. This means that not only is the market believing the Fed will tighten more slowly, but that the number of raises is also declining.
As for the European markets, there are no expectations of changes to the front end of the curve, so we need to look at the longer end to get a feel for what is occurring.
After breaking out earlier in the summer, German 10-year bund yields have given up 25 basis points and have slipped back into the range.
The longer end of the curve does not move solely on short term rate expectation changes, but the moves in both German and US 10 year yields seem to indicate traders are expecting a dovish Fed and ECB. If there was to be a surprise at today’s Jackson Hole symposium, I doubt it would be that either Draghi or Yellen tries to get out ahead of this dovishness by signaling even easier policy.
No, a surprise will most likely look like a Central Bank chief that attempts to put policy back on the previous tighter path.
Most likely they will both duck and try to not disrupt the markets. But there is a better chance than the market is anticipating that one of them (or maybe both of them) surprises with a hawkish statement.
It seems like this is one of those situations where the risk reward favours taking a stab on the dark side of the bond market. If I am wrong, and they don’t make any market moving news, then I suspect the bond market will be unchanged, or slightly higher.
But if I am correct, then I get the feeling there are a lot of longs in the market that might be caught by surprise. With all the recent North Korea/debt ceiling angst over the past couple of weeks, most traders have been scrambling into safer fixed income.
I am playing it by buying steepeners in the front end of the Fed Funds futures and Eurodollar curve. For the past year, the curve has been flattening like a slowly leaking tire, and I think that the risks are definitely skewed towards Janet and Mario trying to stop that loss of air.
If I am wrong, I will give up quickly. This is a short term trade, not a long term directional view.
Although it seems like most traders are Texas-Longhorn-bullish on bonds, I have company with one high profile bear. Jeff Gundlach from Doubleline is holding steadfast with his ursine view. And one of the charts we both like to watch, the copper/gold ratio versus 10-year yield seems to be supporting our position.
So far the relationship seems to have broken down, but I wonder, if we get a calming of the debt ceiling situation and the North Korea situation disappears from the top of Trump’s tweet line, whether bonds might not have a nasty downdraft. I know that is not a popular opinion. Everyone is looking for the opposite to happen. But maybe copper is telling us something that we should be listening to?
I am not a huge believer in cycles, but in a great example of a trader willing to adopt new theories if they support his view (is it still confirmation bias if you are aware of it?), I stumbled upon this great chart from Nautilus Investment Research. The chart shows how the German Bund has been trading in 40 day cycles.
We are due for a rise in yields… But then again, that’s probably just me talking my book.