Clumsy Thoughts on the Front-end

The front-end today has a feeling of capitulation/"get me in!", with the 2yr yield down to a low of 0.67% (!), the lowest since the Dec08/Jan09 deflationary panic and the 14-day RSI at its lowest since the bottom in yields on 16th Dec (the day after the FOMC). With GC trading 15bps the yield pickup of ~2bps/month from here just can't compensate for the potential risk that growth either rebounds strongly or inflationary worries come to the fore (TIPs 5Y5Y still near the top of their range).

To do a very rough back-of-the envelope approximation, term-risk premia from the back-end Eurodollars looks to be about 15bp/year, meaning that over historical carry, there is a mere additional 0.9bps per month pickup over the next two years. Regardless of your view of the Fed being on hold indefinitely, there is very little juice left in this trade.

To look at it another way, Mar11 FOMC OIS is trading at 1.159%, or 82bps of tightening (subtracting risk premia and Effective funds) . A "normal" tightening cycle would involve ~250bps over a 1 year period (ie 25bps at every FOMC meeting), so that would imply around a 1 in 3 chance that the Fed has begun its hiking cycle by Mar11, but the timing of this and also its magnitude are uncertain. If rates are to be "normalised", for example, that might require a series of 50bp clips, given that we are starting from a much lower level. For example, 350bps in 1yr would be 50bps/meeting, and indicate just a 23% probability that a rate hike cycle had begun by Mar11. Conversely, the fact that we are recovering from a financial crisis might mean a much slower normalisation.

Perhaps a "better" way to think about this is to consider the probability of a hiking cycle beginning in any one single month (I assume that 50bps would be the first move, but it could easily be 75bps). In the 15month period to March 2011 there are about 10 FOMC meetings, so this translates to 8bp per meeting. Or in any single month there is about a 16% chance that the Fed begin a rate hike cycle. That is slightly lower than the approximation that assumed 50bps/month, but in the same ball-park, so we can assume the two approaches are roughly consistent with each other.

But what is clear from both approaches is that the market is attaching an extremely high probability to the idea that rates will be on hold well-into 2011.