Fed Rate Hike this Week – Here is the Conundrum

https://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves/

One article read this weekend – think it was from the CNBC app – noted that the surprise with this week’s FOMC announcement could be that that the Fed starts paying interest on member bank deposits ?

I have no insight into whether this is idea is probable or not, but what is known is that the idea was floated years ago when the fed funds rate was at zero, post 2008.

The above link in the first line of this blog is to the San Francisco Fed article that explains the reason for paying interest on bank deposits by the Fed is to set a floor on the fed funds rate. I wasn’t aware that fed funds were that volatile or that the Fed was having trouble keeping the market fed funds rate at the designated target.

The CNBC article wasn’t really clear as to why the Fed is choosing June of 2018 to start paying interest.

There is a 90% chance (per CME futures) that the fed funds rate will be hiked this coming week to the 2% target area.

The conundrum is that – coming into the FOMC meeting this week – bond bearishness (big bets tha bond prices will fall and  interest rates will rise) is very high.

Bernie Schaeffer of Schaeffer’s Investment Research notes in his weekly chart update that “Bond Bears Go Big Ahead of June Meeting” – that was the title of his article and chart this week.

Here is a key part of the article cut-and-pasted for readers benefit:

“Given IEF’s established downtrend and the strong likelihood of another imminent rate hike, it’s no surprise to find that traders are betting on more downside — and in massive numbers. Short interest on IEF more than doubled in the past two reporting periods, and the 8.03 million shares currently sold short represents a new high-water mark for these bearish bets.

Meanwhile, put open interest on the intermediate-term bond fund has been hitting its own fresh highs. Trade-Alert calculates 356,033 puts in open interest on IEF — easily outnumbering the 242,729 calls that have been opened, and a figure that arrives in the 99th percentile of its annual range. And in fact, the current reigning high for IEF put open interest, at 356,192 contracts, was established as recently as last Thursday.

To put these numbers in context, consider the backdrop on IEF ahead of the last Fed rate hike on March 21 (which was widely anticipated). At the time, short interest was less than half what it is now, at fewer than 4 million shares sold short. Likewise, put open interest on IEF checked in at about 246,400 contracts — nearly one-third below current levels.” 

The chart Bernie used was the IEF or the 7 – 10 year Treasury ETF. I prefer to watch the 10-year Treasury note yield, and am short (for clents) the TBF, which is correlated more closely to the TLT or +20-year Treasury ETF.

Any kind of one-sided market like the IEF puts should give investors pause.

Conclusion: With a 3.8% unemployment rate and the nonfarm payroll number back above 220,000 per the June 1 report, it’s hard to think the FOMC won’t move this week, but what happens to the 10 and 30-year yields is the question.

Average hourly earnings are up y/y to 2.5% – 2.7%, meaning all Treasuries out to the 10-year have zero real returns (return after subtracting for inflation).

My own opinion is that the 10-year Treasury yield has to continue to work higher to offer investors positive, inflation-adjusted returns.

We’ll see though – that level of bearishness coming into the Fed announcement usually results in an opposite move, or in this case a strong rally in Treasuries could follow.

Thanks for reading.

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