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Bob Michele
Bob Michele
CIO & Head, Global Fixed Income, Currency & Commodities

Two Handfuls of Holiday Gifts ………

Posted on December 18, 2014
  • J-Yell and the Fed: wage inflation………..normalizing the Fed Funds Rate with so little growth and inflation is going to be troubling….unless we begin to see a deeper and more robust labor market recovery
  • OPEC: valves on their oil pumps that can also turn to the right, not just to the left……who knew lower oil prices would be so contentious?
  • Agency Mortgages: Sector of the Year……Fed tapering meant that mortgages were supposed to lag all other sectors this year, especially corporates……looks like everyone had already raced for the exit in 2013
  • ECB: alphabet blocks that spell Q E ……SMP, LTRO, OMT, TLTRO just aren’t the same
  • Pension Funds: a do-over……equities may be about 5% higher since year end, but the 130 bps drop in long bond yields has wreaked havoc on their liability estimates and de-risking plans….
  • High Yield: a day in court…ok, spreads got a little tight and there’s that energy weighting…..BUT, defaults are still low and corporate fundamentals sound…… yields at over 7% just don’t seem fair
  • BOJ: the Fed’s printing presses…’s only fair that the Old Original Quantitative Easers should inherit all the toys as others exit……
  • Regulators: dramamine…..I suppose if it becomes too costly for dealers to deal, everyone’s in for a pretty volatile ride at times
  • Emerging Market Debt: an inferiority complex…….Russia, Argentina, EMFX, China – all seem to frustrate…….yet money keeps flowing into the sector
  • Bond Investors: duration…………all the gluts (oil, savings, liquidity…), the deflationary pressures and the search for yield continue to force government bond yields lower…..maybe some yield on cash thanks to the Fed will change that in 2015…
Deepa Majmudar
PM, Inflation Strategies

Market or Fed?

Posted on December 18, 2014

Last Friday as I was watching the capitulation in inflation markets to levels not seen since 2008, I was staring at my Bloomberg terminal gasping for a ray of hope and there it was – a headline just flashed across my screen ‘University of Michigan survey of inflation expectations increased from 2.8% to 2.9% for the year ahead and the 5-10yr inflation expectations rebounded from 2.6% to 2.9%’. Wow…compare that to the marked based inflation expectations (TIPS breakevens) which are almost zero for the 1yr ahead and around 2% for 5y5y forward. Even after accounting for the effects of the recent drop in energy prices, the disconnect between the market and the survey based inflation expectations seemed staggering.

Deepa Chart_Fed 5y5y Inflation Breakeven Rate_171214_200dpi 600x400 pixels

This brought up the obvious question – what kind of response should we expect from the Fed? Which inflation measure would be the most relevant to them? Fortunately, we didn’t have to wait too long – the Fed statement yesterday shed light on their thinking about this.

In the last October’s FOMC statement, the Committee had noted that “survey-based measures of longer-term inflation expectations have remained stable” and glossed over the market based expectations as transient. At that time, it made sense as the catalyst for the decline was primarily technical. But now the drop in inflation expectations has happened amidst a larger backdrop of slowing global growth, huge decline in oil/energy commodity prices and increasing global economic weakness.

The market had increasingly started to expect a dovish tilt from the Fed and they didn’t disappoint. While the sport of slicing and dicing and analyzing every word of the Fed statement may go into full swing now, the bottom line is that it was seen as dovish enough and the market reaction was favorable. They would not want to choke growth or inflation and they will be reasonable and balanced about it as the data evolves.

Yesterday was an important day for inflation – both CPI and FOMC within hours of each other. The November CPI continued to show the themes we’ve been observing for a while – strong Shelter and Core Services partially offset by the weakness in Core Goods and drop in Energy prices. But as important as this CPI was to the market, it seemed like the star of the show, CPI, took a backseat to the director of the show, the Fed.

Taking a longer term view, the US is a large, service-based economy and most of the US inflation is domestically generated. The longer dated inflation (expected or realized) should not have a strong correlation to a sudden shock in oil prices unless it is expected to persist for a long time. So if the domestic growth remains on track, especially the strength in the labor markets and the corresponding wage growth, it shouldn’t be long before higher inflation risk premium gets priced into the market – or at least that’s one of my (many) New Year’s wishes.

Abbreviations: Fed: US Federal Reserve, FOMC: Federal Open Market Committee, TIPS: Treasury Inflation-Protected Securities, CPI: Consumer Price Index


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