2023 Presumptions
Trading interest rates will be a lot more complicated in 2023. STIR futures will always be a function of inflation, employment and the central bank reaction function over time. However, there are many subplots that require careful monitoring. Here are some things I am watching for in 2023. I’m going to keep everything short for now, and I may elaborate in a future post next year.
FED REACTION FUNCTION
My previous post explained why I thought the market was pricing in too much ease though 2024. I mentioned that John Williams’ reaction function meant the hurdle for an ease is high. If we take a fresh look at the Fed’s Summary of Economic Projections from the December meeting, we see that they think the Unemployment Rate at the end of 2023 will rise to 4.6 (from 4.4) and they STILL don’t think they will be easing in 2023. I see the signs of economic weakening as much as the next guy, but I’m not sure unemployment gets to 4.6, because…
WHERE DA WORKERS BE AT?
… people still aren’t showing up to work! I am baffled that over the past year, with stimulus ending and the cost of living increasing, that we haven’t seen more re-entrants to the labor market. For the unemployment rate to rise, you actually need to have people looking for work! Given that the number of employed workers is essentially the same as in February 2020, despite the increase in population, we are still missing bodies in the economy. A Philly Fed paper implied that Q2 2022 Establishment Survey payrolls could be revised down over a million jobs. So it wouldn’t surprise me if say 2022 payrolls were eventually revised down closer to 2 million jobs for the year, to be more inline with the Household Survey. It doesn’t matter if there are fewer payrolls, if people stay out of the labor market. It is not clear what the catalyst for getting workers back is, but I don’t see why this pattern will reverse suddenly next year. Even with layoffs in mortgages / real estate and some small tech layoffs, it’s not clear to me if these workers wouldn’t be absorbed back into the economy.
INCOME
That means wages may be sticky. The Fed thinks that to have stable 2% inflation, wages have to be closer to 3%. I think wages are going to be an unofficial precondition to getting a Fed ease (in addition to their two official criteria of inflation and employment). We see continuing high income in things like the Social Security cost of living adjustment being 8.7% for 2023, and the various unions across the US and Europe negotiating 5-10% annual raises. 66 million people receive Social Security.
RETAIL SALES
Not only are early retirees not coming back en masse post-COVID, they appear to be spending like mad on things like travel, experiential events, and luxury goods (along with the “haves” still “having” plenty of money). The combination of COVID and US expected age declining may have caused people to embrace a carpe diem mentality to do the things they’ve always wanted to do (myself included). It is not clear if this is a one year or multi-year event. But this spending seems to be offsetting the lower spending from the “have nots” - especially for services, whose prices the Fed is paying close attention to. I fully expect goods spending to be lower next year from disinflation. But services spending could stay supported.
CHINA REOPENING
I’m wondering to what extent part of the recent manufacturing weakness is because China was locked down. While we don’t export much to China, the global supply chains are all interconnected. China should be “fully reopen” perhaps by the end of Q1, after COVID rips through the economy. It will be sad to hear about the potentially millions dead, but they may be all the stronger for it when it is over. 1.4 billion immune Chinese could be a driver for global growth, assuming Xi’s idiotic policies don’t continue to drive the Chinese economy into the ground. There are arguments for why a China reopen could ease price pressures (supply chain pressures abating) or increase price pressures (commodity prices increasing). It will be interesting to see what happens.
BOJ
It is unlikely that the BOJ is done. Kuroda is leaving next April, and it’s very possible we get a hike and/or another YCC band around the time he leaves (either as a parting gift, or by his successor). The JPY swaps market is telling a different tale than the manipulated JGB markets. Japanese rates were the last of the low interest rate pillars, and it is cracking.
HOUSING
Housing (and autos) are showing the most affects from the Fed’s rate increases. Housing is another area where the markets seem to be having an anchoring bias. My head is going to explode if I see another idiotic “YOY” housing chart. Show me a change from 2019. Just like the massive spike in used cars will result in an apocalyptic yoy price decline chart, it is the same for housing, which had its own astronomical surge post-COVID. This current spate of housing weakness has very little in common with the 2008 crisis. Sellers have favorable mortgages and are comfortable. Buyers are there but looking for bargains. The lack of transaction volume is both a function of supply and demand. While housing transactions and prices will decline noticeably year over year, it is unlikely house prices will fall materially below the prepandemic trend – not when there is still a demographic need for housing in an undersupplied market. Low volumes suck for people in mortgages and real estate brokerage, who will have to find other work. But mortgage rates are only 50bps higher than before the Great Financial Crisis (when people had no issues buying houses), so it’s not clear transactions wont happen in the longer term. More interesting will be whether the new home builders will start scaling back aggressively, as that is a larger driver of the economy.
NEW YEAR’S RESOLUTIONS
Before I get to the Value on the Curve segment, I wanted to share a few things I have been thinking about this year and for the New Year:
I have mentioned the Haves vs Have-Nots recovery numerous times this past year. Most of us trading interest rate derivatives will be in the former category. Consider supporting people who have not been as fortunate. This not only applies to people in our community, but small businesses whenever possible/practicable.
Globally, Ukraine is going to set a geopolitical and security precedent for decades to come. As we have this brief winter storm pass us in our warm homes, consider supporting the Ukrainian people, who are not so fortunate during their struggle. Their fight is our fight.
Finally, I have decided avoid major purchases originating in Russia or China, whenever possible/practicable. I have nothing against the Russian or Chinese people, but indirectly supporting regimes that are a threat to our own makes no sense. You can find much better products elsewhere anyway.
Since 2020, the world seems to have taken a turn for the worse, whether it’s geopolitically, domestic politically, fiscally, and socially, resulting in a degradation of security in many facets of life. I never worry about things out of my control. But there are plenty of things I CAN control, and so can you.
I want to wish you all the very best for the New Year.
VALUE ON THE CURVE
For all the reasons outlined, I am dubious the central banks end up easing as much as the markets are pricing, as early as they are pricing it. You could have inferred this from my pre-FOMC post, and SR3Z4 (SOFR Dec24 futures) has sold off 26bps since the Fed meeting. I suppose you always need some crisis protection, and call skews were very bid for a while. But even factoring in some reasonable odds of a crisis, it’s not clear rates 18+ months from now are “fair”. You still hear stats hike 70% of economists expect a recession next year (I think the odds are <50%), and almost all investors on TV saying they love buying bonds. The markets tend to be unkind to consensus thinking.
There are good risk/reward ways to play for a slower-easing Fed, like put (fly-like) structures in the reds (say mid 2024 midcurves). You could even consider put structures in the whites if you think the Fed hikes more. I have no strong view on the Fed’s terminal rate. The next CPI will again be low (just from looking at CL1 futures and pricing momentum in goods), so it's plausible the Fed takes a slower and lower trajectory. My view is more that once they determine the terminal rate, they will be patient until they see the sticky core services (excluding housing AND medical1) come noticeably lower. The hard work is not in getting inflation to 4%, it's getting it down to 2%.
A second order trade could be to play for eases in a part of the curve where you think eases are underpriced, say in 2025. Short butterflies starting with Z4 and out may be better risk/reward than short spreads in most countries, unless a longer end selloff does not concern you. Range trading these types of structures have been very profitable last year, and I expect they will continue to be so in 2023. The Fed thinks they will be easing 100bps in 2025. “Don’t fight the Fed” also applies to eases.
I’m not saying we couldn’t have the conditions for rapid eases, but as mentioned previously, the hurdle for aggressive eases are high – especially in Europe. The markets seem a little early on the bull steepening regime that everyone seems to be looking for after the last hike. If eases happen later (timing or on the curve), any bull steepening could happen later (timing or on the curve).
This post lists my “pillars” for why I think interest rates could surprise to the upside next year. I will be looking for changes in any of the factors mentioned above. The economic data and news can always surprise. And if something surprising happens, I will adjust accordingly.
I’ve reached my time for this month. I’m going to attempt to tweet more frequently starting next year (perhaps once a week). Follow me at @curveadvisor on Twitter.
Let me know via a “like” on Substack or Twitter (or just an email) if you like this post. Again, if the sum of new subscribers plus likes is greater than x% I’ll write more frequently than my baseline of once a month.
Note that this is not investment advice, you can lose money, I could be a contrarian indicator, all that glitters isn't gold, haste makes waste, and any other saying that may denote the non-seriousness of this post.
Happy trading!
In case you haven’t noticed, medical services have been down -0.6 and -0.7 the past two CPI reports. Let me know if you’ve ever seen declining medical care costs. This is a result of some bizarre annual seasonal adjustment starting in October and will allegedly last 10 more months.