10Y eurodollar fed

Inner And Outer Limits: Resolving An Inconsistency And What It Means For Risk

An "optimal control problem."

Last Sunday, I brought you some excerpts from a recent JPMorgan note which flagged what the bank’s Nikolaos Panigirtzoglou called a “significant” development that seemed to underscore the idea that the Fed is either headed for a policy mistake or else that late-cycle dynamics are taking hold.

Specifically, JPM flagged the first sign of inversion in the U.S. curve. Obviously, an inverted curve is seen as a precursor to some rather unpalatable outcomes and given that flattening pressure quickly resumed following the bout of bear steepening that accompanied the February selloff, this is front and center in folks’ minds. Here are the key excerpts from the JPMorgan note in case you missed it last weekend:

An inversion at the front end, i.e. between the 2-year and 3-year forward points of the 1-month OIS curve arose for the first time during the first week of January as can be seen in Figure 2. But this slight inversion only lasted for two days at the time and the curve re-steepened significantly in the following weeks. The US OIS curve started flattening again after the February equity correction and the spread between the 2y and the 3y forward points of the US 1-month OIS rate curve entered negative territory last week on March 29th. But it has been hovering between +1bp and -1bp since March 19th suggesting that the current episode of yield curve inversion is more persistent than the brief inversion seen during the first week of January.


An inversion at the front end of the US curve is a significant market development, not least because it occurs rather rarely. As shown in Figure 3, it happened only three times over the past two decades: in 2005, 2000 and 1998. What looked different during these three past episodes relative to today is that the US curve had also been inverted further to the front end, i.e. between the 1y to 2y forward points and not only between the 2y to 3y forward points. However Figure 3 suggests that the 2y-3y forward point spread has been generally leading the 1y-2y one, so it might be a matter of time until the latter turns negative also in the current conjuncture.

The bank goes on to try and determine, via an analysis of flows data, whether this is indicative of the market pricing in a policy mistake or an end-of-cycle dynamic.


I talked to some folks last weekend about that and I did my best to summarize some of those conversations for you.

“So these are spreads to greens (2y fwds) and the 2y fwd is basically the terminal Fed, so the spread between reds and greens (1y vs 2y fwd) is how aggressively the Fed is going to hike,” one analyst said, adding that “the spread between blues/greens (3y vs 2y) is basically how likely it is that greens are the terminal Fed.”

“I don’t think it is a policy mistake,” that person opined.

Another veteran trader I spoke with had this to say about the JPMorgan piece:

It’s a good piece, but JPM’s attempt to differentiate between Fed policy mistake and end-of-cycle dynamics through fund flows is pushing it. Inherent in that assumption is that investors can accurately assess future economic performance. I don’t buy it. Investors get it wrong all the time. I know that I am contradicting myself because if I believe markets don’t matter, then the original yield curve signal is also bunk. Yet I think price means a lot more than flow of funds analysis. Anyways, I am sympathetic to the idea that the yield curve is signaling a slowdown might be imminent.

There’s more, but you get the idea. This is indeed a “significant development” (as JPMorgan puts it), but whether or not it’s indicative of the market pricing in a policy mistake is an open question.

Ok, well that brings us to a new special report from Deutsche Bank’s Aleksandar Kocic and Steven Zeng and let me tell you, they’ve got a lot to say about curve dynamics. They begin by breaking down the mechanics of the Fed hiking cycle into “two parameters”:

  1. Policy gap or outer limits, and;
  2. Eurodollar spreads or inner limits

The first point there will be familiar to regular readers as it harkens back to Kocic’s “shrinking playground” discussion, something we’ve written about extensively in these pages. First, Deutsche reminds you about the simple mechanics of the outer limits:

Policy gap represents the length of the journey, it is the difference between the long rate (the final destination of the cycle) and the shadow rate (the near-term expectations of the Fed). As the Fed hikes, front end outpaces the long rate and the curve bear flattens – long rate is either stationary or sells off slower than the front end. This is the bear flattening mode of the curve. As short rate reaches the long rate, the policy gap closes and rate hikes stop.


Moving to the inner limits, Zeng and Kocic reinforce some of the discussions I highlighted last weekend, noting that “early on in the cycle, the market makes up its mind about where the short rate in the subsequent two years should be –  this is the Green sector of the Eurodollar curve (2Y forwards).”

Ok so given that, it stands to reason that greens will be, as Deutsche calls it, a “pivoting point” for the rest of the ED curve re: pricing the Fed path. When the hiking cycle starts, there’s ambiguity about when it will ultimately end, and in that context, as the analyst I spoke with last weekend put it, “the spread between blues/greens (3y vs 2y) is basically just how likely it is that greens are the terminal Fed.” Here’s Deutsche Bank saying pretty much the same thing:

At the start of the cycle, there is some uncertainty regarding the timing of the terminal Fed, and so, because of that, there is a risk premium priced by the spread between Greens and Blues (3Y forwards). Reds (1Y forwards) are the short-term expectations of the Fed. If the Fed is tightening slowly, Red/Green is wide. But, if the journey is expected to be long, slow hikes in the near term implicitly put their effectiveness in question — they increase the uncertainty about the timing of the end and the risk premium beyond Green sector is higher and Greens/Blues steepen as a consequence. This is the logic behind coordination of the Red/Green and Green/Blue spreads – Greens act as a pivoting point around which the rest of the Eurodollar curve is repricing the Fed path. This is the logic behind the pattern shown in the Figure. Red/Green & Blue/Green spreads are mirror images of each other. They pinch the x-axis towards the end of the cycle. Currently, Blue/Green has compressed to zero, while Red/Green has not.


So, 3y / 2y looks like it’s tipping the end of cycle while, 1y / 2y fwd hasn’t quite made it all the way there or, as Deutsche puts it, “they are still pricing some hikes.” Next, Kocic and Zeng combine the inner and outer limits discussions. They begin by saying this:

Green/Blue has been flat for a long time and has recently inverted. Based on their historical interaction, this flattening appears excessive, even with the current tightness of the monetary policy gap.

That said, they note that with the policy gap having shrunk to inside of 30bp, it would seem as though “we have practically reached the end of the hiking cycle” and “the flatness of Green/Blues is not grossly inconsistent with that.” But if that’s correct, then 1y / 2y has to be “wrong” or, as Deutsche concisely puts it, “Reds should trade flat to Greens”.

They go into a deeper discussion of this and put it in historical context, but I think for our purposes here, suffice to say they illustrate the “current dislocation of the Eurodollar curve [as] reflected in a premature collapse of the Green/Blue spreads relative to the Red/Greens” with the following regression:


Now, recall last weekend we highlighted some excerpts from the above-mentioned Kocic’s note on the restriking of the Fed put. Well everything said above is obviously part and parcel of the same overarching discussion and here’s how Kocic and Zeng bring it all together:

The inconsistency priced beyond the Green sector can be resolved through two modes: bull steepening or bear steepening. Despite both being steepeners, their causes and implications are quite different. A rally led by Greens would be a bull steepening resolution. Continued turbulence and weakness in equities could propagate through financial conditions and force a softening of the Fed path. The market reprices more dovish Fed and Reds and Greens rally (parallel of steepening), while Blues remain static together with long rates. The policy gap remains unchanged, but now the wider spread between Greens and Blues is consistent with the rest of the curve. This is also bullish for risk. It presents effectively restriking of the Fed put closer to ATM and as such is a convexity supply to equities.

Bearish steepening, on the other hand would most likely take place as a result of an exogenous shocks, e.g. a possible change in global flows. It would be transmitted through the long end – the policy gap would open up and repricing of the Eurodollar curve would follow. In all likelihood, such a development would be bearish for risk.

Again, it seems like what’s needed here for stocks to find their footing in earnest is for the turmoil to reach a point where the transmission to financial conditions causes market participants to reprice the Fed path or, more simply, the main positive externality for equities could now come from the Fed.

As far as “fundamentals” and “blockbuster” earnings go, how did that work out for everyone on Friday? It kind of seems like it’s a “sell the news” thing when it comes to Q1 results, as the bar was set high enough to make everyone’s expectations quite difficult to live up to.



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