Monday 5 August 2019

Cut Odds Rising

As it stands this morning, options market-implied odds of the Fed cutting by at least another 125bps by year-end are about 1 in 4.

Since Wednesday’s close, the odds of the Fed cutting by at least another 75bps by year-end have roughly doubled. As it stands this morning, the Eurodollar options-implied odds (fitted to the FF curve & fwd FRA/OIS spreads) of a) the Fed only cutting once more by 25bps in September or, b) the Fed cutting rates by at least another 75bps are about equal.

Market-implied odds using the Eurodollar options surface, fitted Fed Funds curve & fwd FRA/OIS spreads.

Here are what the options market assign as the likeliest outcomes for the Fed this year (there are other possibilities, obviously – these are the most likely as defined by current options skew):

Last week played host to price action that was truly historic in the bigger picture. On Wednesday, both equities & gold sold off by more than 1% & the front-end of the Treasury curve sold off as well. That’s the first time ever the Fed has managed that on the same day as they’ve announced a cut in policy rates. Oh, and lest we forget, the dollar also strengthened on a trade-weighted basis.

Obviously, that front-end sell-off didn’t last long. In the long-term historical context, the 25bp+ rally we’ve seen in 2-year yields in the 3-day period AFTER the day of a Fed cut is not without precedent. But the last time since the start of the 1990s that we got a larger rally in absolute terms was in early 2001 – when yields were close to 5% (they followed that one up with another cut the same month, and then another 9 before the calendar year was up).

Blue = number of times we've seen lower yields (negative) or higher yields (positive) since 1990 after a Fed cut. Orange = number of times implied by a standard normal distribution model.

That’s all in the context of a trade “spat” that seems to be growing into a much larger conflagration. Despite the warnings of nearly every street economist that this will generate a significant inflationary impulse to consumers, over the next year, the market will charge you more to protect against inflation going below 0% than it will charge to protect you against inflation going above 2%. The last time this skew was so lopsided, the market was still expecting the Fed to hike rates this year.

It’s turning into a bit of a choppy affair today, so will update with some additional thoughts later in the afternoon.