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Summary of My Post-CPI Tweets (June 2017)

June 14, 2017 1 comment

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Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI day! People looking past CPI at 8:30 but…not me!
  • Last 2 CPI prints were very low. The first was a 1-off wireless telecom debacle, read about that effect here.
  • Last month’s CPI weakness was in core services – in medical care & rent of shelter. Harder to ignore but unlikely to be in freefall.
  • Consensus core CPI is for another weak print, only 0.16% or so. Economists believe disinflation is upon us. I think that’s premature.
  • Last May’s core CPI was 0.21%, so that’s the hurdle to get acceleration in y/y figures.
  • WOW! At this rate I will have to change my Twitter handle. Each month is more shocking. m/m core 0.1%, not sure on the rounding yet.
  • 06% m/m on core CPI, so again incredibly weak. y/y at 1.74%, producing the scary optic of a drop from 1.9% to 1.7% on the rounded core
  • This is an amazing chart.

  • waiting for the data dump, but housing, medical care, apparel subcomponents all decelerated.
  • So the upshot is…core prices overall are unchanged from February. That’s right, 0% core inflation over 3 months.
  • Yes, it was telecom that made 0% possible and that won’t be repeated. But still striking. Here is the index itself.

  • So Dec, Jan, Feb core inflation is rising at a 3% annualized pace. next 3 months, zero. That’s not supposed to happen to core.
  • Breakdown now. In Housing, Primary rents remain solid at 3.85% y/y, unch. But Owners’ Equiv plunged (for it) to 3.25% from 3.39%.
  • Picture of OER: this is a dramatic shift in this index, and frankly hard to explain given home price increases.

  • Medical Care decelerated to 2.66% from 2.95%. But w/in MC, drugs rose to 3.34% vs 2.62%. Professional svcs flopped to 1.00% from 1.58%
  • CPI/Med Care/Professional Services, y/y. Doctors suddenly don’t need to be paid.

  • Apparel had been at 0.45% y/y, fell to -0.94%.
  • The Fed funds rate is too low and almost certainly rises today. But with a sudden zig in CPI…it wouldn’t SHOCK me if they delayed.
  • Back to housing – we’ve believed OER was ahead of itself for awhile. Adjustment is just really sudden.

  • in the biggest-pieces breakdown, core goods is at -0.8% y/y while core services is down to 2.6%.
  • US$’s recent decline (2y change in trade-weighted $ is only +7%) means core goods are losing the downward pressure of last few yrs.
  • But the dollar’s effect is lagged significantly. We’re still seeing effect of prior strength.

  • Here are the four pieces of CPI, most volatile to least. Starting with Food & Energy (21% of CPI)

  • Core goods (33%)

  • Core services less Rent of Shelter. Yipe!

  • Got my percentages wrong. Food & Energy is 21%. Core goods is 19%, core services less ROS is 27%. Rent of Shelter is 33%.
  • Rent of Shelter. 27% of overall CPI. I still find it hard to believe this is going to collapse, but as I tweeted earlier it was ahead.

  • My early estimate of Median CPI is 0.18% m/m, 2.28% y/y down from 2.37%.
  • One thing to keep in mind is that in June and July we drop off 0.15% and 0.13% from y/y core. So core should bounce back some. (??)
  • I mean, we can’t average 0% core going forward, right?!? Otherwise @TheStalwart and @adsteel will never have me on again.
  • core ex-shelter down to 0.59% y/y. Lowest since JANUARY 2004!

  • Interestingly, the weight of categories inflating more than 3% remains high. The pullback is in the far left tail.

Well, it’s getting harder to put lipstick on this pig. The telecom-induced drop of a couple of months ago was clearly a one-off. But the slowdown in owners’-equivalent rents is merely putting it back in line with our model, and so it’s hard to believe that’s going to be reversed. And I’m really, really skeptical that there has been an abrupt collapse in the rate of increase of doctors’ wages.

Except, what if there is a shift happening from higher-priced doctors to lower-priced doctors? This sort of compositional shift happens all the time in the data and it’s devilishly hard to tease out – for example, in the Existing Home Sales report it is sometimes difficult to tell if a change in home prices is coming from a broad change in home prices, or because more high-priced or low-priced homes are being sold this month, skewing the average. So this kind of composition shift is possible, in which case each individual doctor could see his wages increasing while the average declines due to the composition effect. I have no idea if this is what is happening – I’m just making the point that if it is, then this effect could be more persistent and not the one-off that the telecom change was. However, I am skeptical.

I do not believe that we have seen a turn in the inflation cycle. With money growth persistently above 6%, it would take a further collapse in money velocity from already-record-low levels to get that to happen. Forget about the micro question, about whether movements in this index or that index look like they’re rolling over. The macro question is that it is hard to get disinflation if there’s too much money sloshing around, whether or not the economy is growing.

But that being said, the Fed doesn’t necessarily believe that. There is a tendency to believe one’s own fable, and the fable the FOMC tells itself is that raising interest rates causes growth to slow and inflation to decline. Although the effect is spurious, we are currently seeing somewhat slower growth (for example, in the recent slowing of payrolls) and we are seeing lower core inflation. It is a low hurdle for the Fed to believe that their policy moves are an important part of the cause of these effects. Of course, they’re not – the tiny changes the FOMC has made in the overnight rate, even if it had been propagated to significant changes in longer rates – which it hasn’t been – or resulted in slower month growth – it hasn’t, especially if you look globally – would not have had much effect at all. But that won’t stop them from thinking so. Ergo, the chance that the Fed skips today’s meeting, while small, are non-zero. And there is a much greater chance that the “dot plot” shifts lower as dovish members of the Fed (and that’s most of them) back away from the feeble pace of increases they’d been anticipating.

Bond Vigilantes Still Slumber

I read an article recently that noted the 65-75bp rise in Treasury yields over the last year or so, and sought to explain, through a labyrinthine line of reasoning/model, that most of the rise was due to the “reflationary” trade, with the Fed hopelessly behind the curve. The model the author used depicted inflation expectations as being fairly directly tied to the rise in inflation outcomes that we’ve seen: headline inflation has risen from below 1% at the middle of last year to 2.4% year-over-year ended last month.

This approach was, at one time, fairly standard. Since there was no way to directly observe inflation expectations, people measured real rates by taking current interest rates and subtracting trailing 1-year inflation, reasoning that recent inflation is a good proxy for expectations. Indeed, you will still see some economists and bloggers referring to the “recent decline in real rates” that has happened since headline inflation has risen about 250bps since mid-2015 (see chart, source Bloomberg) while 10-year rates are approximately unchanged over the same time horizon.

With this framework, economists would say that real interest rates have fallen precipitously and are now roughly zero, whereas two years ago they were over 2%.

Of course, that old way of doing things is nonsense today. Because past inflation is highly influenced by changes in energy prices (oil prices bottomed in early 2016), trailing inflation is in fact a pretty poor measure of longer-term inflation expectations, and we no longer need to rely on this method because we can directly observe real interest rates, and to some extent market measures of inflation expectations.[1] Here are the current levels, along with 1-year and 2-year changes, in real rates and inflation over the last one and two years (source: Bloomberg; Enduring Investments calculations):

So what has really happened to longer-term real rates and inflation expectations? Over the last two years, 10-year real yields have risen about 27bps, with roughly unchanged 10-year inflation expectations, producing a 25bp rise in nominal interest rates. Over the last year, those numbers are +38bps and +27bps, leading to a 65bp rise in 10-year nominal yields.

Those figures give the central bank tremendous credit for not being behind the curve. Over the last two years, core and median inflation has risen 0.3% while 10-year expectations have been stable. Over the last year, core inflation has fallen a bit (though that has a lot to do with the quirky plunge in telecom prices last month, which should be reversed this month) while median has risen about 10bps. Still, there’s no panic at all in inflation markets. Real yields have risen only 16-65bps over the last two years, despite 75bps of rate hikes.

The Fed very probably is well behind the curve, but the market doesn’t think so. The bond vigilantes haven’t even begun to light their torches yet.

[1] Since market nominal interest rates are lower than they would be if the Fed had not bought a few trillion in securities, breakevens and inflation swaps are probably lower than true inflation expectations would be if the market was freely trading, but since at some point market rates will begin to anticipate the unwind of the Fed’s balance sheet we can’t really say for sure.

Categories: Federal Reserve, TIPS

Summary of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation, published in March 2016. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • Pretty big market day! Importantly, CPI: remember last month was big upside surprise, and driven by unusual suspects – core goods.
  • There’s a decent base effect hurdle today, as last Feb was 0.25% on core CPI. Consensus today is for a very weak 0.2% (almost 0.1%).
  • The consensus forecast clearly says that most economists see last month’s shocking 0.31% on core as one-offs.
  • Consensus expectation is for core to slip back to 2.2% from 2.3%. But then, last month they thought we’d fall to 2.1%.
  • Hurdles get easier next month: March ’16 saw 0.09% core CPI, and then a series of low 0.2s & 0.1s. So core is going up this summer.
  • Here is what I said about last month’s figures: https://mikeashton.wordpress.com/2017/02/15/summary-of-my-post-cpi-tweets-36/
  • 5 mins to CPI. Sources say the headline number is trading 243.34 (which would be -0.04% on headline) in the CPI derivs mkt.
  • core at 0.21%, higher than consensus expectations of 0.15% or so. Keeps y/y at 2.22%, down from 2.26%. But next month is an easy comp.
  • Monthly core CPI prints.

  • I don’t pay much attention to headline but it was a little high, y/y up to 2.74%. Only matters if it affects tenor of Fed discussion.
  • In major subgroups: Housing rose to 3.18% vs 3.12%. Need to see if that’s energy. Apparel fell back, as did health care.
  • w/in housing, Primary Rents slipped to 3.91% from 3.93%, Owner’s Equiv to 3.53% from 3.54%. So the housing bump was elsewhere.
  • Looks like the housing increase was mostly household energy, 4.46% from 3.51%. So no biggie as the kids say.
  • Apparel 0.42% vs 0.99%. The big jump last month was mostly reversed. Overall core services 3.1% and core goods dropped back to -0.5%
  • Last month the big story was that core goods had caused the jump in core CPI. Looks like these were mostly seasonal issues after all.
  • Transportation 6.3% vs 4.8%. That’s mostly gasoline. New & used cars slipped. But rising: parts, maintenance, insurance, airfares.
  • In Medical Care, big drop in medicinal drugs 4.19% vs 4.85%. Also drop in prof svcs (2.68% v 2.94%). THOSE are the one-offs this month.
  • Here are y/y med care & housing, source of the big upward pressure recently. But remember this month the housing is mostly energy.

  • Four more major subcategories. Recreation is the only one moving higher, but it’s a heterogeneous group & hard to decipher.

  • Quick estimate of Median is 0.21% m/m, 2.52% y/y, not quite a new high. Official figure will be out later.
  • Next month we should have core back over 2.3% and a shot at 2.4%, thanks to easy comp in March.
  • 10y inflation swaps still below current median inflation.

  • Mkt pretty confident in Fed: CPI mkt pricing: 2017 2.0%;2018 2.2%;then 2.2%, 2.1%, 2.2%, 2.2%, 2.3%, 2.4%, 2.5%, 2.7%, & 2027:2.5%.
  • This CPI report takes inflation off the boil, but not off the burner.
  • One more chart: weight of CPI categories over 3% inflation y/y.

Let’s face it. While this month’s CPI held some intrigue because of last month’s surprising spike, nothing about the figure was likely to change the outcome of today’s FOMC meeting and probably not the tenor of the statement or post-meeting presser. So, in that sense, this was a much less-significant report than last month’s release.

At the same time…let’s not lose sight of the fact that this was still an above-consensus CPI report. While the consensus was broadly correct that some of the jumps in core goods categories from last month were one-offs, and at least partially retraced this month, it’s still the case that y/y core inflation is going to keep rising through the summer merely on base effects. If the Fed wants to be hawkish and tighten more than the market currently expects (I think that nothing could be further from the truth, with Yellen at the helm, but she seems to dislike President Trump enough that she might forget some of her dovish leanings), then they will continue to have cover from inflation reports for a while.

Going forward from that, there are two inflation questions that will be resolved: (1) Will core goods recover and rise, indicating a broadening of inflation impulses that could produce a longer-tail upside? And (2) will housing inflation flatten out or decline since rent inflation is currently rising faster than even our most-generous models? If it does, then core inflation might stabilize near the current level, or even decline.

I have trouble figuring out what the mechanism would be for inflation to flatten out at these levels, from the macro-monetary perspective. Money growth remains brisk and higher interest rates should eventually goose velocity. I don’t see much prospect of money growth rolling over while banks are neither capital- nor reserve- constrained. And it’s hard to see interest rates heading back down while central banks shift into less-accommodative stances. I have more confidence in the macro-monetary (“top down”) model at longer time frames, and more confidence in the bottom-up analysis at shorter time frames. And for years they’ve told the same story: inflation should be rising, and it has. But there is a conflict between these perspectives that is coming later this year. How it resolves will be the story of the next 3-6 months.

That Smell in the Fed’s Elevator

March 7, 2017 5 comments

A new paper that was presented last week at the 2017 U.S. Monetary Policy Forum has garnered, rightly, a lot of attention. The paper, entitled “Deflating Inflation Expectations: The Implications of Inflation’s Simple Dynamics,” has spawned news articles such as “Research undercuts Fed’s two favorite U.S. inflation tools”(Reuters) and “Everything the Market Thinks About Inflation Might Be Wrong,”(Wall Street Journal) the titles of which are a pretty decent summary of the impact of the article. I should note, because the WSJ didn’t, that the “five top economists” are Stephen Cecchetti, Michael Feroli, Peter Hooper, Anil Kashyap, and Kermit Schoenholtz, and the authors themselves summarize their work on the FiveThirtyEight blog here.

The main conclusion – but read the FiveThirtyEight summary to get it in their own words – is that the momentum of the inflation process is the most important variable (last year’s core inflation is the best predictor of this year’s core inflation), which is generally known, but after that they say that the exchange rate, M2 money supply growth, total nonfinancial credit growth, and U.S. financial conditions more broadly all matter more than labor market slack and inflation expectations.

Whoops! Who farted in the Fed’s elevator?

The Fed and other central banks have, for many years, relied predominantly on an understanding that inflation was caused by an economy running “too hot,” in that capacity utilization was too high and/or the unemployment rate too low. And, at least since the financial crisis, this understanding has been (like Lehman, actually) utterly bankrupt and obviously so. The chart below is a plain refutation of the notion that slack matters – although much less robust than the argument from the top economists. If slack matters, then why didn’t the greatest slack in a hundred years cause deflation in core prices? Or even get us at least close to deflation?

I’ve been talking about this for a long time. If you’ve been reading this blog for a while, you know that! Chapters 7-10 of my book “What’s Wrong With Money?: The Biggest Bubble of All” concerns the disconnect between models that work and the models the Fed (and most Wall Street economists) insist on using. In fact, the chart above is from page 91. I have talked about this at conferences and in front of clients until I am blue in the face, and have become accustomed to people in the audience staring at me like I have two heads. But the evidence is, and has long been, incontrovertible: the standard “expectations-augmented-Phillips-Curve” makes crappy predictions.[1] And that means that it is a stupid way to manage monetary policy.

I am not alone in having this view, but until this paper came out there weren’t too many reputable people who agreed.

Now, I don’t agree with everything in this paper, and the authors acknowledge that since their analysis covers 1984-present, a period of mostly quiescent inflation, it may essentially overstate the persistence of inflation. I think that’s very likely; inflation seems to have long tails in that once it starts to rise, it tends to rise for some time. This isn’t mysterious if you use a monetary model that incorporates the feedback loop from interest rates to velocity, but the authors of this paper didn’t go that far. However, they went far enough. Hopefully, this stink bomb will at last cause some reflection in the halls of the Eccles building – reflection that has been resisted institutionally for a very long time.

[1] And that, my friends, is the first time I have ever used “crap” and “fart” in the same article – and hopefully the last. But my blood pressure is up, so cut me some slack.

The Fed Needs More Inflation Nerds

January 30, 2017 5 comments

Earlier today I was on Bloomberg<GO> when the PCE inflation figures were released. As usual, it was an enjoyable time even if Alix Steel did call me a ‘big inflation nerd’ or something to that effect.

The topic was, of course, PCE – as well as inflation in general, how the Fed might respond (or not), and what the effect of the new Administration’s policies may be. You can see the main part of the discussion here, although not the part where Alix calls me a nerd. A man has some pride.

My main point regarding the PCE report was that PCE isn’t terribly low, but rather right on the long-run average as the chart below (all charts source Bloomberg) shows. Of course, PCE has been lagging behind the rise in CPI, but because it had been “too tight” previously this isn’t yet abnormal.

spread

However, in the interview I didn’t get to the really nerdy part. Perhaps my ego was still stinging and so I didn’t want to highlight the nerdiness?[1] No matter. The nerdy part is that the reason PCE is low is actually no longer because of Medical Care, but because of housing. This next chart plots the spread of core CPI over core PCE, through last month’s figures, versus Owners’ Equivalent Rent (OER).

vs-housing

Housing has a much higher weight in the CPI than in the PCE, and as you can see the plodding nature of OER means that the correlation is somewhat persistent because housing inflation is somewhat persistent. Right now, OER (which, frankly, I thought would have leveled off by now) is rising and showing no signs of slowing, and this fact has served to widen the CPI-PCE spread back to its historical average and likely will cause it to widen to an above-average level. I suppose the good news there is that it is still true that outside of housing, core inflation is still not rising aggressively. Core services ex-housing are looking perkier, but core goods continue to languish as the dollar remains strong. The strength of the dollar almost beggars belief if it’s true that the rest of the world hates us now, but it is what it is.

The bigger point, for markets, is “so what?” There is nothing about a 1.7% core PCE that presents any urgency for Chairman Yellen. As I said on the program: as Yellen approaches the end of her chairmanship (in January 2018, since she insists Trump won’t chase her out before), I believe it is much more likely that she wants to be remembered for pushing the unemployment rate very low – because she believes inflation is easily controlled – than that she wants to be remembered for being a hawk that stopped inflation from getting going. She isn’t worried about inflation, and so the question is whether she wants to be criticized for adding “too many” jobs, or not adding enough. Not that monetary policy has much to do with that, but I believe she clearly will err on the side of keeping policy too loose. The Fed isn’t tightening this week, and I find it unlikely that they will tighten in March, unless inflation expectations rise considerably further than they have already (see chart of 5y5y inflation forward from CPI swaps, below). Even after the big rally since late last year, 5y5y is well below the long-term average through 2014.

5y5y

And even if inflation expectations do rise further, the excuse from the chair will be easy: expectations are rising because the end (and possible reversal) of the globalization dividend and the imposition of tariffs will lead to higher prices. But there is nothing that Fed policy can do about this – it is a supply-side effect, just as high oil prices due to OPEC production restraints would represent a supply-side effect that the Fed shouldn’t respond to. So the excuses are all there for Dr. Yellen. History will show that she missed a chance to shrink the Fed’s balance sheet and avert the worst of the next inflationary upturn, but that history will not be written for some time.

[1] Ridiculous, of course. I embrace my nerdiness, at least when it comes to inflation.

Categories: CPI, Economy, Federal Reserve Tags:

The Yield Curve is Critical of Fed Credibility

I was planning to write an article today about the shape of the yield curve. Since the Global Financial Crisis, the Treasury curve has been very steep – in early 2010 the 2y/10y spread reached almost 300bps, which is not only unprecedented in absolute terms but especially in relative terms: a 300bp spread when 2-year yields are below 1% is much more significant than a 300bp spread when 2-year yields are at 10%.

2s10s

But what I had planned to write about was the phenomenon – well-known when I was a cub interest-rate strategist – that the yield curve steepens in rallies and flattens in selloffs. The chart below shows this tendency. The 5-year yield is on the left axis and inverted high-to-low. The 2y/10y spread is on the right axis. Note that there is substantial co-movement for the recession of the early 1990s, throughout the ensuing expansion (albeit with a general drift to lower yields), in the recession of the early 2000s, the ensuing expansion, and the lead-up to the GFC.

and5yyields

I was ready to point out that the steepening and flattening trends tend to be steady, and I was going to illustrate that they feed on themselves partly for this technical reason: that when the curve is steep, steepening trades (selling 10-year notes and buying duration-weighted 2-year notes, financing both in repo) tend to be positive carry and therefore easier to maintain, while on the other hand when the curve is flat the opposite tends to be true. So the actual causality of the relationship between steepening and rallies is more complex than it seems at first blush.

It would have made a very good article, but then I noticed that since 2010 or so the tendency has in fact reversed!

Specifically, from 1987-1995 the correlation of the level of the 5-year spread to the level of the 2s/10s spread was -0.78. From 1995-1999, the correlation flipped to +0.48 (but I didn’t bother to de-trend the data and I suspect that correlation stems more from the strong, 350bp decline in interest rates from 1995-1999). From 1999-2009, the correlation was -0.81. Since 2010, the correlation is +0.60: the curve has tended to flatten in rallies and steepen in selloffs. And, in the recent bond market selloff, the curve steepened as long rates rose further than short rates.

This is interesting. Clearly, carry dynamics cannot explain why the relationship is inverted. I think the answer, though, is this: since 2010, the overnight has been anchored. That isn’t different than in the past – from late 1992 to early 1994, the Fed funds target was anchored at 3%. But the difference is that back then, traders acted as if the Fed might eventually move the overnight rate in a meaningful way. Since 2010, investors and traders have attributed no credibility to the Fed, with virtually no chance of a substantial move over a short period of time. Accordingly, while short interest rates historically have tended to be the tail wagging the dog, while longer-term interest rates move around less as investors assume the Fed will remain ahead of the curve and keep longer-term inflation and interest rates in a reasonable range…in the current case, short term rates don’t move while longer-term rates reflect the market belief that rates will eventually reach an equilibrium but over a much longer period than 2 years as the Federal Reserve is dragged kicking and screaming.

I happen to agree, but it isn’t a great sign. I suppose it was destined, in a way – “open mouth” operations can only work in the long run if the Fed is credible, and the Fed can only be credible in the long run if it delivers on its promises. But it hasn’t. This is probably because the Fed’s forecast have been worse than abysmal, meaning its promises were based on bad forecasts. In such a case, changing one’s mind when the data changes is the right thing to do. But even more important, if your forecasts are frequently wrong, is to shut up and stop trying to move markets where you want them with “open mouth” operations. I have said it for 20 years: the worst thing Greenspan ever did was to make “transparency” a goal of the Fed. They’re just not good enough at what they do to make their activities transparent…at least, if they want to maintain credibility.

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Administrative Note: On Monday I will be conducting the third and final in a series of webinars on inflation and inflation investing. This series will be done on the Shindig platform, sponsored by Enduring Investments, in cooperation with Investing.com. This webinar is on “Inflation-Aware Investing.” You can sign up directly with Shindig here, or find the webinar link at Investing.com.

Who Keeps Selling These Free Options?

November 22, 2016 Leave a comment

It seems that recently I’ve developed a bit of a theme in pointing out situations where the market was pricing one particular outcome so completely that it paid to take the other side even if you didn’t think that was going to be the winning side. The three that spring to mind are: Brexit, Trump, and inflation breakevens.

Why do these opportunities exist? I think partly it is that investors like to be on the “winning side” more than they like ending up with more money than they started. I know that sounds crazy, but we observe it all the time: it is really hard (especially if you are a fund manager that gets paid quarterly) to take losses over and over and over, even if one win in ten tries is all you need to double your money. It’s the “wildcatter” mindset of drilling a bunch of dry holes but making it back on the gusher. It’s how venture capital works. There are all kinds of examples of this behavioral phenomenon. I am sure someone has done the experiment to prove that people prefer many small gains and one large loss to many small losses and one large gain. If they haven’t, they should.

I mention this because we have another one.

December Fed Funds futures settled today at 99.475. Now, Fed funds futures settle to the daily weighted average Fed funds effective for the month (specifically, they settle to 100 minus the average annualized rate). Let’s do the math. The Fed meeting is on December 14th. Let’s assume the Fed tightens from the current 0.25%-0.50% range to 0.50%-0.75%. The overnight Fed funds effective has been trading a teensy bit tight, at 0.41% this month, but otherwise has been pretty close to rock solid right in the middle except for each month-end (see chart, source Bloomberg) so let’s assume it trades in the middle of the 0.50%-0.75% range for the balance of the month, except for December 30th (Friday) and 31st (Saturday), where we expect the rate to slip about 16bps like it did in 2015.

fedl01

So here’s the math for fair value.

14 days at 0.41%  (December 1st -14th)

15 days at 0.625% (December 15th-29th)

2 days at 0.465% (December 30th-31st)

This averages to 0.518%, which means the fair value of the contract if the Fed tightens is 99.482. If the Fed does not tighten, then the fair value is about 99.60. So if you buy the contract at 99.475, you’re risking…well, nothing, because you’d expect it to settle higher even if the Fed tightens. And your upside is 12.5bps. This is why Bloomberg says the market probability of a 25bp hike in rates is now 100% (see chart, source Bloomberg).

fedprob

There is in fact some risk, because theoretically the Fed could tighten 50bps or 100bps. Or 1000bps. Actually, those are all probably about equally likely. And it is possible the “turn” could trade tight, rather than loose. If the turn traded at 1%, the fair value if the Fed tightened would be 99.448. So it isn’t a riskless trade.

But we come back to the same story – it doesn’t matter if you think the Fed is almost certainly going to tighten on December 14th. Unless you think there’s a chance they go 50bps or that overnight funds start trading significantly higher before the meeting, you’re supposed to be long December Fed funds futures at 99.475.

The title of this post is a question, because remember – for everyone who is buying this option at zero (or negative) there’s someone selling it too. This isn’t happening on zero volume: 7207 contracts changed hands today. That seems weird to me, until I remember that it has been happening a lot lately. Someone is losing a lot of money. What is this, Brewster’s Millions?

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An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

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