Market Memo: A Short Macro Insight

STIR may have gotten ahead of itself

There’s some confusion currently in macro, especially in STIR.

You’ll all recall that I’ve been pretty vocal on the need for cuts to be priced into 2024 since October. We owned Z4 and M4 calls on SOFR since Oct 30th, and played the Euribor March 2024-2025 spread anticipating more cuts priced in.

However, now, it’s gotten a bit insane. Lets take a look at the spread between March 24 SOFR and December 2024:

So, in simple terms, the market is pricing 125-150bps of rate cuts between H4 and Z4.

That’s reasonable. After all, it’s an election year. And I definitely understand that there’s going to be political pressure in an election year to cut rates. The confusing part is that we seem to be essentially priced to perfection for “the Fed cuts rates relatively aggressively into the election and then pretty much stops”. There are only about 50bps of cuts priced into the entire year of 2025. While that’s certainly one way for us to get down to the neutral rate, it’s possible that the market is taking a narrative way too far.

There’s two ways that the current pricing ends up being correct. One is that the Fed cuts very quickly and aggressively into the election and then cools off. But, it’s worth considering, cutting too quickly and aggressively would risk upsetting the market in a “what does the Fed know that we don’t” manner.

Most market participants that rely on STIR markets to determine what is currently priced in for the path of the policy rate have come to understand the concept that there is a “recession premium”, i.e. the optionality priced in further along the curve that deals with the chance there’s some tail risk that forces the Fed to cut interest rates in a manner akin to COVID.

What this has meant, essentially, is that when anchors and pundits said “the market currently expects the Fed to cut 150bps during 2024”, what it actually meant was “a certain percent of participants believe the Fed will have to cut to zero/near zero because of a severe recession, and then another larger percent believe the Fed is going to cut some amount less than 150bps, and those two cohorts have agreed to price in the optionality of the former cohort’s view”.

While this is always how it works, the first cohort was very overrepresented during the hiking cycle (with us having just come out of ZIRP and recession being a consensus view for quite some time). 

I have spoken to a lot of traders on my recent trip about the macroeconomic outlook, the most cunning (and perhaps cynical) among them are the ones I spoke with the longest, and the view that permeates among them is that the Fed will cut too fast, too far because of political pressure and then inflation will reaccelerate. So it’s worth considering too that perhaps what we’re witnessing is the inverse of the recession premium on this fly - the “reacceleration of inflation premium”. The market might not be pricing in the Fed cutting 5 times more in 2024 than 2025, but rather pricing in the risk that the Fed’s cutting cycle gets cut short by inflation coming up in 2025.

Either way, my own view is that the rate path down will be a bit less steep than this in 2024:

At the end of the day, the only thing that matters is finding asymmetry. Maybe this rate path is correct, maybe it’s an overreaction. What I see when I look at this situation is a market that may have gotten a bit carried away, and one that gives a pretty decent chance of pushing out a few of these cuts into 2025 if the current economic momentum we’ve got continues.

TRADE: SELL Z4 ON H4Z4Z5 FLY

ENTRY: -0.835

TARGET: -0.33

I see the H4Z4Z5 fly as having well-defined risk/reward and offering a natural entry point at -83.5bps with a well defined stop at the pre-SVB lows about 5bps (or 10 ticks) lower. My base case is that there is one more cut in 2024 than 2025, while I could see the “political pressure” thesis unwinding early and potentially pricing in more cuts in 2025 than 2024. So if we expect the market to price up to -30bps on this fly (one more cut in 2025 than 24 with some probability of 2) we are putting on 5bps of downside risk for 50bps upside reward. As you can see below, this is a natural spot for the fly to bounce, technically speaking:

Naturally, cuts getting pushed out down the curve would result in higher rates on the front end (and probably a parallel shift higher or bear flattener) so I view this also as a bit of a rate hedge. I have some plays in my portfolio that benefit from the lower rates narrative continuing, including some real estate plays, and I think that the risk reward here is such that I can use this spread as a cheap enough hedge to protect those plays.

The risk to this position would be if we had a severe and unexpected recessionary impulse, like a banking crisis (one that isn’t “Fisher Price’s Baby’s First Interest Rate Risk” mini-crisis like the one we had in March). It would have to be really bad and really immediate to take this to even more extremes, because the way things are now I think pricing any more cuts into the front year on the curve is essentially saying “the Fed must hit the panic button NOW”.

As in even if we had a “severe and unexpected recessionary impulse” I don’t think the Fed will cut aggressively right away. That’ll likely only accelerate as the impulse and its economic nature gradually become confirmed. It’s very rare to get a shock whose nature and interpretation are immediately and universally understood and accepted, which typically is why the Fed is slow to react.

Don’t get me wrong, there are still some things about the market reaction over the past couple weeks that confuse me a bit. But part of playing this game is separating recognizing asymmetry and executing to take advantage of it from being fully comfortable that you know exactly what’s going on.