Disappearing Playgrounds

The playground is shrinking. In fact, it just disappeared.

Over the past several weeks, market participants marveled at various manifestations of what look like end-of-cycle dynamics in rates, a strange and, to some, inauspicious setup for a Fed that’s still a month away from the first hike.

“[T]he curve has flattened hard in forward space, and eurodollars beyond the middle of next year are even inverted, an awfully unusual circumstance for markets to find themselves in,” Bloomberg’s Cameron Crise wrote Wednesday, on the way to exclaiming, “We’re pricing the approaching end of the tightening cycle before it’s even begun!”

That’s the gist of it, captured in just two sentences. In a pair of notes out this week, Deutsche Bank’s incomparable Aleksandar Kocic expanded on this, using the “playground” characterization of the policy gap (longtime readers will be familiar).

The spread between the 5Y5Y rate (the Fed’s destination) and the 1Y1Y rate is the policy gap, and defines the boundaries for activity. The wider the gap between short rates and the terminal rate, the more scope for vol. Currently, that relationship is breaking down entirely (figure below). The policy gap has tightened, but volatility is taking off. “In our view, this reflects the fracture across the horizons,” Kocic said. “The market has abdicated on the long-term and is following the Fed in the short-run as the only source of manageable risk, one to which probability assignment is possible.”

In recent notes, Kocic has discussed the extent to which markets, lacking visibility on inflation and thereby bereft when it comes to longer-term macro forecasting, have instead focused exclusively on the Fed and short-term monetary policy “as if it were the only thing that matters,” as he put it in November.

The dynamics discussed above are an extension of that. “This bifurcation between curve slope and vol is a function of low confidence of the market and the elevated levels of uncertainty regarding the future rates path,” he wrote.

The idea that the tightening cycle is over before it started is thus something of a false optic, created by i) an inability (on market participants’ part) to assign probabilities to anything other than the next policy meeting, ii) questions about the efficacy of Fed policy vis-à-vis the macro and thereby rates and, likely, iii) the simple fact that forecasting long-end yields has a long history of being an exercise in futility anyway.

In a separate note, Kocic injected a bit of color into the eurodollar discussion, which is welcome because typically, the only thing colorful about eurodollars is the nomenclature. “The interplay between Bullard’s comments and the Fed response, together with the market’s reaction, is by now a standard pattern of Fed’s convexity management,” he wrote, adding that,

The isolated “dissident” call for excessive (>25bps) and, possibly, inter-meeting rate hikes – a sort of panic button push – was a maneuver of Fed’s convexity buying. There are two factors which prompted this move. First, Fed is always short a far-OTM put on its credibility. The latest inflation print, together with their inaction (no hikes and QE) have moved the strike of that put closer to ATM. Fed had to cover that convexity short. Second, in the light of the ongoing inflation rise, they needed to free some maneuvering space by getting an option to respond more aggressively, if needed, without disturbing the markets too much. Fed reacted swiftly in an attempt to produce calm by talking about recentering its internal consensus and carefully distancing themselves from the outlier opinions and overly hawkish actions without entirely removing it from the discourse. They have now a more comfortable position from which they can guide the markets. This is effectively a negative supply shock of convexity. The market underwrote that option by flattening the curve through massive repricing of the front end: REDs/GREENs flattened and GREENs/BLUEs inverted further, while policy gap, 1Y1Y/5Y5Y collapsed.

That gives you some useful context when it comes to the interplay between Fedspeak, the Committee’s implicit role as convexity manager and the topic du jour in rates circles.

As for the curves pedestrians are accustomed to pondering, BofA’s Ralph Axel said the Fed is very likely to trigger an inversion in the most widely cited mainstream recession indicator.

“A Fed that rapidly gets to neutral will likely invert the 2s10s,” he said, adding that in BofA’s view, that’s not “controversial or problematic” given high inflation and a tight labor market.