What now?

So what happens now?

The US employment data confounded both the expectations of predictive models (such as, cough cough, that belonging to your author) and the fears of the marketplace, registering solidly on just about every front.  The reaction in some quarters of  the fixed income market was swift and substantial, with eurodollars notching their largest daily decline since the infamous "y'know, six months, that type of thing" press conference from Yellen last March.

On that occasion, the weakness was meant to be bought, as it was a clear overreaction to a misstatement from a new chairman.  This time around, the weakness has brought, say, EDZ5 to a level that has proved pivotal in the past.   On that basis alone, it might be tempting to buy a few or at least cover some cheeky shorts.

On the other hand, ED's and fixed income generally still looks really quite rich when viewed through a number of prisms.  Looking at calendar spreads, which tend to correlate reasonably well with direction, there'd appear to be more room to the downside.   The EDZ5/M6 spread, for example, currently discounts some 42 bps of rate rise in the six months (and 4 Fed meetings) between expiries.   That seems relatively modest if the Fed is indeed on the path to launching a tightening cycle later this year, and on the chart there appears to be another 10 ticks of downside, easily.  The good news is that Macro Man sold this spread last Thursday; the bad news is that he didn't sell nearly enough.

While Yellen has pooh-poohed the dots on a few occasions, they still serve a useful purpose in terms of illustrating where members of the Fed think rates ought to be (assuming a given forecast profile, natch.)  Let's suppose that only those in the bottom half of the distribution get to vote (which we know is not true, because Looney-Tune [and non-voter] Narayana Kocherlakota is quite obviously the low man on the totem poll, or at least the dot forecasts.)

If we take the average of these forecasts for the end of the next few years, what do we find?  They are all above the prevailing rate implied by Fed funds futures, in some cases dramatically so.

Now, there is of course no guarantee that the Fed will deliver as much as implied by the dot forecasts.   By the same token, there's also no guarantee that they deliver as little as implied by those forecasts, either; after all, monetary policy is a pretty inertial affair.   From Macro Man's perch, the asymmetric risk looks to be to the downside of these contracts/upside in yield.

That a few observers are throwing out sub 1% 10 year forecasts does little to dissuade him of that view.  That many erstwhile bears have apparently given up trying to short rates (natural selection is, after all, a powerful influence!), leaving the market to some degree in the hands of the "buy at any price" crowd, would suggest that prices have comfortably exceeded equilibrium.   Of course, disequilibria can persist for some time.  

For only the second time since Paul Volcker's infamous "Saturday Night Special", 10 year Treasury yields have traded below nominal GDP growth for an extended period.   The first of those, the infamous "conundrum", helped facilitate the housing and credit bubbles that are largely the reason that things suck for so many people these days. 

What's interesting to note is that even during that period, 10y yields at least had the decency to trend higher.   The same is also true of the 1950's -70's, when Treasury yields remained well below the level of nominal GDP growth.  In the current episode, however, yields have trended lower.  That the Fed has bought an amount that would even Dr. Evil blush is, of course, a major explanatory variable for this.

That the Fed is a) no longer buying, b) starting to contemplate a rise in short rates, and c) well and truly able to sell some of their holdings if they don't think markets reflect desired financial conditions does not yet seem to be reflected in the price.

Of course, oil is the elephant in the room, and to be sure it has put a severe dent in the level of headline CPI.  Then again, Fed models view it as a net stimulant (Macro Man is inclined to agree) which should push up the level of GDP.

There are people who think that the Fed will never be able to hike again.  Then again, there were people in 2009 who thought that stocks would never rally again, or that credit markets would never re-open again.  Trading is all about assessing the balance of probability.  From Macro Man's perch, current pricing provides an opportunity, with the prospect of a catalyst over the summer or early autumn (and a nearer-term catalyst when "patient" is dropped from the statement.)

Call him crazy, but he's sticking to his guns (and his positions.)