In the past few days, various measures of the probability of a March rate hike have spiked. These probability measures are all fraught with some issues, but it is clear that the Fed has made a big push to get March on the table, and they have been very successful at that.
This effort to get the market to focus on March makes sense, and is consistent with the Fed's past behavior -- most noticeably in June 2016.
Realistically, the Fed wanted the market to price it in so that they feel they have the option open. Plus, it would be difficult to get to the three hikes that the Fed has been talking about since the December meeting without March being a realistic option: Otherwise, they run the risk of backloading everything and failing to meet their target again.
For a long time, fixed income markets have been betting against the Fed delivering (eurodollar futures have continuously underpriced the dots), but that trade has seemed wrong.
Bloomberg Calculated Probability of March Rate Hike
Does it Really Matter if They Hike?
I've thought March was more on the table than the market did, but we are roughly aligned now on the likelihood. The bigger question is, "does it matter?"
My short answer is that the risk of market reaction probably depends on the shape of the curve more than anything.
The Yield Curve vs. XLF
Without a doubt, financials have been a big contributor to this rally -- that might be about to end.
The ever-important 2s/10s curve is flattening as XLF continues to rise.
Given the still-anemic personal consumption expenditures data (fourth-quarter PCE came in at a disappointing 1.2% in December), it is quite possible to see a rate hike met with significant flattening, as the market may perceive that the Fed is nipping growth too early.
There is a lot of discussion on whether the official data, particularly the PCE data, really captures the inflation most of us see in our daily lives, but I think a March hike will be met with a bear flattener -- the front end will take more seriously the threat of multiple hikes this year and next, while the back end will remain dubious on growth and issuance.
If the curve starts flattening, look for some pressure to start on financials.
Other Concerns About Financials
As curves flatten, other concerns might hit the financials:
- After a fast pace of new issuance late last year and early this year, we could see it decline, which would put a damper on bank fees.
- M&A activity may be delayed as CEOs wait for clarity from the Administration on what a tax plan could eventually look like -- another damper on earnings for financials.
- Transaction volumes might slow -- home sales slowed (largely due to supply constraints) and refinancing activity is lower with rates higher, and even secondary bond trading has been skewed towards recent new issuance. All of this is potentially slowing the pace of fixed income revenue generation (I hope I'm wrong on this one).
So I would be looking to exit financials -- and watch them as a barometer of overall market risk (the current 11-point gain on S&P futures today seems a bit disappointing, given the tone of last night's speech, which is another possible sign of market fatigue).
I like credit spreads here. CDX IG (investment grade credit default swaps) should be trading with a 5 handle -- especially as we come into the roll. I don't really like actual bonds here. A lot of issuance is trading near where it came -- a potential round of "Flippers Remorse" could be in store for the bond market, as people decide to exit new issues and find that the multiple-times-oversubscribed books were filled with a lot of padded orders and short-term holders.
Finally, I continue to like floating rate products: the IG floaters with call protection, leveraged loans -- and yes, CLOs, which, in spite of their recent tightness, have room to run, particularly the senior tranches.
The bottom line is that I'm not particularly concerned about the Ides of March, but it gives us a few more things to watch.
On the Volatility Index (VIX) pieces that I've been mulling over, I have had a lot of discussions with people about the "create to borrow" mechanism, where some of the ETF creation is due to increased shorts. The data I have easy access to is delayed, but shows that short interest is increasing -- making the possibility of a VIX shock higher than I previously thought (but more on that in the coming days).