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The things left unsaid

| June 7, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The market started last week implying roughly a 70% chance the Fed would cut by the end of July and a 99% chance it would cut by the end of the year. Eleven times last week, Fed governors had public opportunities to walk the market back. Governors addressed LIBOR, labor, banking, housing, trade and the mechanisms of monetary policy. A few talked about growth and inflation. None walked the market back. Sometimes the things left unsaid matter the most.

If the Fed wanted to guide the market away from the view implied in current pricing, it had plenty of chances (Exhibit 1). Fed speeches often are the continuation of FOMC debate by other means. And the speeches last week suggest no one around the FOMC table is talking about raising rates. If anything, a few governors clearly or subtly tipped in the other direction. Bullard, a known dove, suggested a cut would help drive up inflation expectations and provide insurance against a slowdown. Powell highlighted the Fed’s intentions to “sustain the expansion.”  Williams argued that low inflation is a “pressing problem.”

Exhibit 1: No clear effort in recent Fedspeak to walk the market back from cuts

Source: Amherst Pierpont Securities

Evans noted Tuesday in a CNBC interview that “the market sees something that I haven’t seen yet in the national data.” That might have been the only faint homage to symmetric policy.

By the end of the week, the implied probability of a late July Fed cut had jumped to 86% and a cut by December above 99% (Exhibit 2). With the close of business Friday, the Fed moves into the quiet period before the June 19 FOMC. Until then, the market has had the last word.

Exhibit 2: The market now implies high confidence in Fed cuts

Source: Bloomberg, Amherst Pierpont Securities

Recipe for volatility

The Fed has good reason to take a new interest in growth because of the uncertainty created by tariffs. It’s not that the potential impact of tariffs is beyond measure. The Fed already has started coming up with estimates of the tariff impact. It’s the difficulty of predicting timing, magnitude and scope by geography and product. With the introduction of tariffs into negotiations of US immigration policy with Mexico, the calculus should now more clearly include both economic and political impact. Knowledge of how those tradeoffs might play out arguably is held only in the small circle of people negotiating with US trade counterparties. That makes it difficult for people running companies or people running investment portfolios to anticipate the outcome, and that may already have started constraining investment and growth.

The market seems to be viewing volatility from tariffs increasingly as part of the base case. The MOVE index of implied volatility on rates has jumped to its highest level since early 2017 (Exhibit 3). And even through recent realized volatility in rates has only slightly exceeded levels from March this year, implied volatility has moved much higher than March. The excess of implied volatility over realized suggests the market isn’t just weighing recent developments. It’s weighing possible future developments, and it sees future volatility over the horizon.

Exhibit 3: Implied volatility has jumped higher than realized volatility might imply

Source: Bloomberg, Amherst Pierpont Securities

And add the risk of inflation

Ironically, the same tariffs threatening growth also could add a pulse to inflation if the tariffs go in place. The higher and broader the tariffs go, the bigger the impact. But it should only be a pulse, not a trend. Once the cost of tariffs filter into prices, trend inflation should prevail. It still creates an interesting tradeoff for the Fed, at the very least to communicate a strategy of dealing with transitory inflation. It may also help explain the recent steepening of the 2s10s yield curve.

Own convexity

Given the risks around tariffs, the likelihood that tariffs have become part of the market dynamic for at least this year if not next and difficulty of anticipating the direction of their application, it seems a simple call to own convexity. Either trade into more convex products or buy options outright. The magnitude of realized and implied volatility looks likely to rise. Convexity should perform well.

* * *

The view in rates

The descent of US 10-year yields has continued to 2.08%, and the market is confident that the Fed will ease. The market in the last week has raised the odds of a Fed cut this year from 95% to 99%. Persistent volatility from trade conflict stands to keep yields low or drive them lower for now. The US and Mexico may resolve their tariff negotiations, but the US and China remain on war footing. The US and China meet June 28-29 at the G20. If no credible resolution comes there, the market will likely assume that trade and tariffs are key part of the base case.

 The view in spreads

Spreads in credit should continue to widen as trade frictions pick up. It’s an appropriate repricing as prospective global growth comes under pressure. Agency MBS could see a softening of bank demand, but it should still outperform credit. Since the US announced new tariffs on China on May 9, MBS has performed much better than credit, and correlations suggest flows from credit into MBS. That should continue.

The view in credit

Corporate credit on the margin looks like it is improving from its state last year. Various measures of leverage paint a mixed picture, but many are improving. Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

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