Being Patient With An Impatient Fed

For now, that believe is a June hike. We have our own reservations, and we strongly caution against being too committed to this consensus. The upside-downside risks are way too asymmetric for big punches to be thrown in the ring. We feel it is just not worth it at this juncture.
— Business Of Finance, 14 March 2015

It seems the Fed has lost its patience after its March 19 policy statement release and press conference. Of course we use the word "patience" rather loosely here. In our minds, the presence or absence of one word does mean much in the grander scheme of policy guidance and the eventual bombshell.

There was something for doves and hawks. Analysts have been expecting "patience" to be dropped from Wednesday's statement, and the FOMC did not disappoint on that front. What the committee did however bring to the table was a whole new phase of uncertainty; something almost everyone detests.

Markets had been highly anticipating the FOMC event Wednesday. Risk was instantly bid post release, the dollar tanked together with bonds yields across the curve, while commodities including energies and precious metals rallied on a knee jerk. The post mortem a day after reveals that much of the exuberance in the commodities space has fizzled away - crude oil has nearly retracted all post FOMC gains; while precious metals are seeing limited upside. The dollar has strengthened after flash crashing during early Asian trading to above 1.1 to the Euro. We note that most dollar crosses (major FX pairs) saw a daily range north of 400 pips. We don't get this very often; perhaps reflecting the pent-up volatility that has been suppressed preceding the statement. Chart courtesy of The WSJ

Markets had been highly anticipating the FOMC event Wednesday. Risk was instantly bid post release, the dollar tanked together with bonds yields across the curve, while commodities including energies and precious metals rallied on a knee jerk.

The post mortem a day after reveals that much of the exuberance in the commodities space has fizzled away - crude oil has nearly retracted all post FOMC gains; while precious metals are seeing limited upside. The dollar has strengthened after flash crashing during early Asian trading to above 1.1 to the Euro. We note that most dollar crosses (major FX pairs) saw a daily range north of 400 pips. We don't get this very often; perhaps reflecting the pent-up volatility that has been suppressed preceding the statement.

Chart courtesy of The WSJ

We feel that the FOMC statement and Chairwoman Janet Yellen's press conference did their job in communicating to the markets a new message - that a rate liftoff will be anything but a certainty. The good news for risk meanwhile, was that the Fed sounded more dovish than it did in January's statement, and certainly December's. This sentiment has been reflected in the money markets. We speak more about this further on.

The markets had been basing restlessly for the entire half of the week, much to the chagrin of heavily exposed portfolios. There is no doubt that Wednesday's event was a market mover. We'll get to the highlights of the event later on, but readers should understand that the Fed collectively added more dovishness than hawkishness to the landscape. Broadly speaking, this is negative for the Dollar, and positive for equities and bonds. However, as we go to print, most of the dollar weakness has already been erased. Surprise?

The Fed has once again given the markets the green light to continue on their multiple expansion, while themselves reigning in overly dovish interest rate guidance. We have always been of the opinion that the Fed was a master communicator, and they surely haven't disappointed this time round. The market likes it Goldilocks warm.

Dropping "Patient" Doesn't Mean Impatient

During her press conference, Fed head Janet Yellen said that the Fed's policy will be heavily data-dependent, and that the Fed wasn't determined on the timing of a rate hike. There is still a good deal of ambiguity to which the markets are left to be discombobulated by.

Jokingly, moments after the initial FOMC statement was published, we posted the following on social media:

Strangely, that was what the market seemed to have felt too. In the aftermath of the release, stocks and bonds ripped higher while the TWI Dollar Index fell by more than 1%. Markets saw a rush out of liquidity and into risk; hedges were unwounded in quick succession with the VIX trading below 14.

The biggest change from January's statement has to be the committee's economic assessment. This was where most of the Redline changes were made. This will come as no big surprise to regular readers, as we noted 3 weeks ago: Global trade raises red flag; Goldman says be worried about global growth.

Before we continue, these were the headlines from the FOMC statement:

Strangely, that was what the market seemed to have felt too. In the aftermath of the release, stocks and bonds ripped higher while the TWI Dollar Index fell by more than 1%. Markets saw a rush out of liquidity and into risk; hedges were unwounded in quick succession with the VIX trading below 14.

The biggest change from January's statement has to be the committee's economic assessment. This was where most of the Redline changes were made. This will come as no big surprise to regular readers, as we noted 3 weeks ago: Global trade raises red flag; Goldman says be worried about global growth.

Before we continue, these were the headlines from the FOMC statement:

  • Fed drops patient stance on interest-rate rise guidance

  • Fed says economy "has moderated somewhat", job market improved

  • Fed wants to be "reasonably confident" on inflation for liftoff

  • Fed says rate rise also tied to more labor market improvement

  • Fed says rate guidance doesn't mean FOMC decided on liftoff timing

  • Fed says rate rise "remains unlikely" at April FOMC meeting

  • Fed says housing remains slow, "export growth has weakened"

  • Fed repeats international developments to be taken into account

Key Redline changes:

Disinflation and deflation has been the theme as of late across the developed economies. The Fed has acknowledged this problem of low inflation. The Redline also highlights concerns over prices. Market based measures of inflation (breakevens) continue to point lower before improving slightly towards 2H15. The Fed's forecasts seem overly optimistic in this light. Chart courtesy of The WSJ

Disinflation and deflation has been the theme as of late across the developed economies. The Fed has acknowledged this problem of low inflation. The Redline also highlights concerns over prices. Market based measures of inflation (breakevens) continue to point lower before improving slightly towards 2H15. The Fed's forecasts seem overly optimistic in this light.

Chart courtesy of The WSJ

  • Fed notes that recent growth has "moderated somewhat" instead of "expanding at a solid pace"
  • Fed adds that "export growth has weakened"

  • Fed removes measures of inflation compensation "have declined substantially" and replaces with "remains low"

  • Fed changes "inflation is anticipated to decline further" with 'remain near its recent low level"

Forecasts:

  • Fed sees 2015 GDP growth of 2.3% - 2.7% vs. 2.6% - 3% (Dec. est)
  • Fed sees 2015 jobless rate at 5% - 5.2% vs. 5.2% - 5.3% (Dec. est)

  • Fed sees 2015 PCE inflation at 0.6% - 0.8% vs. 1% - 1.6% (Dec. est)

  • Fed sees longer run unemployment rate at 5% - 5.2% vs. 5.2% - 5.5% (Dec. est)

US macroeconomic data has missed expectations by the most since 2009, according to data recorded by Bloomberg. While this is been partly due to the over exuberant forecasts, there has indeed been a weakening of positive momentum in the different economic indicators. Chart courtesy of Bloomberg

US macroeconomic data has missed expectations by the most since 2009, according to data recorded by Bloomberg. While this is been partly due to the over exuberant forecasts, there has indeed been a weakening of positive momentum in the different economic indicators.

Chart courtesy of Bloomberg

Having said all that, we feel the biggest concerns to the Fed at this juncture are prices and economic momentum. Recall that we made know the point about US macro economic data missing expectations by the most since 2008, and that the US was actually the most disappointing economy so far into 2015. This is hardly palatable, but the markets and especially the greenback seem fixated only on the labor market. In our eyes, this behavior is not only perplexing but outright precarious.

The only consistency in the Fed's language over the last 4 policy meetings has been the improvement in the labor market and labor conditions. Forecasts also reflect the improving development. Markets have been spurred on by positive jobs data (NFPs & Initial Claims), but we feel this is another major mis-guidance that could spell a lot of pain once the chickens come home to roost. Companies cannot keep hiring while preserving elevated margins in an environment of slowing economic momentum.

We hope the Fed's acknowledgement of this development has taught the markets a lesson of wishing for undue excesses. We're talking about the strength of the dollar, in case readers haven't yet realized. We have done major adjustments to our trading portfolio following Wednesday's statement and will tend to stand clear of excessive exposure to the dollar in the currency markets.

Money Markets Speak Up

We feel that the general investing and trading community has been a little misguided for a while now, but we can't blame them. The "dots" as they are aptly called, are the most used benchmark for anchoring expectations of the timing and magnitude of any possible future rate hike. These dots represent each of the 16 voting members' selection on the interest rate - time series plot. There is little reason for most people to seek an alternative measure of guidance - because it is these FOMC members that ultimately pull the strings, and the market reacts accordingly.

The chart below highlights how all 16 FOMC members have voted in their latest meeting. Compared to January's dot-plot, the Fed is collectively more dovish on their guidance. The difference is even starker when compared to the September plot.

This chart depicts the 16 dots, representative of each FOMC's member's votes for the time series. One interprets the each dot as one vote at a specific interest rate (Fed Funds Rate), for each period (median for 2015, 2016, 2017 & beyond). Juxtaposing to September's dot-plot, Wednesday's plot was markedly more dovish with substantial decreases in guidance as we have illustrated. Even for 2015, the FOMC felt that rates would come in at 0.625% on average. We personally find this absolutely ludicrous - the American economy would implode at that rate of interest. In 2016, the dots point to 1.875%, then 3.125% in 2017, and so on. It seems like the path of rate normalization has taken on a steeper slope despite outspoken concerns over inflation, inflation expectations, and economic momentum. Chart courtesy of Zero Hedge, Illustrations ours

This chart depicts the 16 dots, representative of each FOMC's member's votes for the time series. One interprets the each dot as one vote at a specific interest rate (Fed Funds Rate), for each period (median for 2015, 2016, 2017 & beyond).

Juxtaposing to September's dot-plot, Wednesday's plot was markedly more dovish with substantial decreases in guidance as we have illustrated. Even for 2015, the FOMC felt that rates would come in at 0.625% on average. We personally find this absolutely ludicrous - the American economy would implode at that rate of interest. In 2016, the dots point to 1.875%, then 3.125% in 2017, and so on.

It seems like the path of rate normalization has taken on a steeper slope despite outspoken concerns over inflation, inflation expectations, and economic momentum.

Chart courtesy of Zero Hedge, Illustrations ours

How to read this chart: Each of the 5 panes plots the price histories for the respective 30-Day Fed Funds Futures contract (March, June, September, October, and December). The orange dots represent where prices were on the 12/17 FOMC statement release date. The red dots represent where prices were on the 12/28 FOMC statement release date. The blue dots represent where price were one day after the 3/18 FOMC statement release date (latest). The way we determined if the market viewed the release as hawkish o dovish was via a simple litmus test. If implied rates were higher than they were at during January's FOMC event, it is seen as hawkish. If implied rates were lower, it is seen as dovish.

How to read this chart:

Each of the 5 panes plots the price histories for the respective 30-Day Fed Funds Futures contract (March, June, September, October, and December).

The orange dots represent where prices were on the 12/17 FOMC statement release date. The red dots represent where prices were on the 12/28 FOMC statement release date. The blue dots represent where price were one day after the 3/18 FOMC statement release date (latest).

The way we determined if the market viewed the release as hawkish o dovish was via a simple litmus test. If implied rates were higher than they were at during January's FOMC event, it is seen as hawkish. If implied rates were lower, it is seen as dovish.

However, we prefer to rely on the financial markets for insight, the money markets in this particular case. Specifically, we look at the 30-Day Federal Funds Futures; these interest rate futures trade on the CME. The reason we look to the futures market for guidance is because they remain the purest and most efficient form of information inclusiveness.

For readers who are foreign to this, the pricing of these Fed Funds future contracts are on a discounted basis (Par - Discount Rate = Current Price). For instance, the 30-Day Fed Funds Future for August delivery (ZQ Q5) currently trades at 99.765, this implies a discount rate of 0.235% (100 - 99.765) for a period of slightly over 5 months.

We have done up a simple illustration on the chart to the left. Contrasting to dots, the Fed Funds market have placed increased emphasis on the second half of the year.

Looking at the implied Fed Funds Rate for March and June, both were lower than they were at during December's and January's FOMC statement. It is only when we pass September that the Fed Funds futures start to price in a more hawkish Fed, shifting significantly to October as the first plausible month for a hike, one month up from September as had previously been anticipated.

Futures implied roughly the same rate for September as they did during January's FOMC statement release (~28bp). This is very close to the actual Fed Funds Rate of 0 - 0.25%. Looking at October's contract, we start to see the first significant change. Markets are pricing in a 0.355% rate, roughly 10bp above current. This is followed by December's contract implying a rate of 0.46%, another 10bp hike.

All these seem to make logical and systematic sense to us when we place whatever we currently know into their proper context. Remember, the dots are telling us to expect rates to be at 0.65% at the end of 2015. We cannot wrap our heads around this. At the current decelerating pace of economic growth, the Fed is more likely to only hike rates once either in their October or December meeting, as opposed to twice - which the dots seem to imply. We believe any rate hike will be in incremental 10bp steps. A 25bp hike is plausible but we feel it is unlikely.

The Race Is On

Lastly, we allow Goldman to add color to the already vibrant canvas. Goldman expects a September rate hike. We expect an October hike at the earliest; December isn't too far out for us either.

We shall see who blinks first on this call.

From Goldman:

The March FOMC statement and projections suggested that September rather than June appears to be the most likely date for the first hike of the fed funds rate. Although the change to the "patient" forward guidance was close to expectations, the shift in the "dot plot" was most consistent with two rather than three 25 basis point hikes to the target range occurring in 2015. In addition, changes to the Committee's economic assessment were a bit more dovish.
MAIN POINTS:
  1. As widely expected, the FOMC decided to drop its "patient" formulation in its forward guidance regarding the date of the first rate hike. It explicitly noted that a hike at the upcoming April meeting was unlikely, while stating that the Committee will hike "when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term."
  2. Changes to the Committee's assessment of economic activity were generally dovish, with growth at a "solid pace" downgraded to growth having "moderated somewhat." In particular, "export growth weakened."
  3. The median projection for the fed funds rate (or "dot") fell 50bp to 0.625% at end-2015, fell 62.5bp to 1.875% at end-2016, and fell 50bp to 3.125% at end-2017. Two participants again indicated that a hike would not be appropriate until 2016, while one indicated a target range of 25-50bp at end-2015 and seven indicated a target range of 50-75bp at end 2015 (a group that is highly likely to include the leadership of the Committee), most likely consistent with a first hike in September. The median longer run projection was unchanged at 3.75%, but many participants reduced their longer run dot by 25bp.
  4. The FOMC also released a new Summary of Economic Projections. The mid-point of the central tendency of the unemployment rate fell 0.15pp to 5.1% in 2015Q4, 0.1pp to 5.0% in 2016Q4, and 0.15pp to 4.95% in 2017, implying a 0.15pp undershooting of the longer-run or “structural” rate, which declined 0.25pp to 5.1%. Real GDP growth declined 0.3pp to 2.5% in 2015, 0.25pp to 2.5% in 2016, and 0.2pp to 2.2% in 2017. Longer run growth was unchanged at 2.15%. Headline PCE inflation fell 0.6pp to 0.7% in 2015, but was little changed after that. Core inflation fell 0.3pp to 1.35% in 2015 and fell 0.15pp to 1.7% in 2016, but was unchanged at 1.9% in 2017.
  5. There were no dissents.
  6. Our forecast remains for a September hike, but the risks now appear slightly skewed toward a later liftoff.