Via ConvergEx’s Nick Colas,
If U.S. stocks have stabilized – granted, a big “If” – you can thank the fact that markets don’t believe the Federal Reserve’s outlook on interest rates.
According to the latest CME Group’s contract pricing, Fed Funds rates will end 2015 at 43 basis points. That essentially signals a less-than-100% chance of being at 50 bp in 14 months; the Fed’s own estimates are for Fed Funds to reach 127 basis points by that time. Only three of 17 Fed officials who submit estimates for inclusion in the now-famous “Dot Plot” are lower than the market’s own estimate of future monetary policy. Looking at 2016, the disparity between market expectations and Fed estimates is even broader. Policy makers at the Fed believe rates should be at 2.17%; the Fed Funds futures contract sits at 1.27%. In the everlasting debate about whether markets want good or bad economic news, we seem to have a winner. Bad news will keep the doves “Fed” (yes, a pun… it’s Friday) and the hawks at bay. A spate of good U.S. news while the rest of the developed world slows is the worst potential outcome in this narrative.
When should you bluff while playing poker? Common wisdom has it that you should only occasionally – and randomly – bet as if you have a superior hand even if you don’t. The logic is straightforward: you want to induce some persistent sense of doubt among your competition. Maybe you have a strong hand, and maybe you don’t. The incremental uncertainty will drive pots higher and, when you do have that full house kings high, the payoff will be that much greater.
Of course, calling another player’s bluff has its own psychic rewards. You tell them that they have a lousy ‘Poker face’ and recommend they never, even lie to their spouse. Maybe you also mess with them by saying they always sneer subconsciously when they pretend to have a stronger hand than they actually do. Then watch them try to keep their face absolutely still over the next dozen hands. Good times… Good times…
If you’re wondering why equity markets have stabilized in the past 24 hours – after a fashion, anyway – you can chalk a large part of the rebound to the market essentially calling the Federal Reserve’s bluff on the future path of interest rates. Sure, the Fed has been fairly bold though 2014, throwing its Rolex into the pot and even threatening to find the title to the Ferrari if it comes to that, just to show it is serious about staying in the game. “Short term rates will begin to normalize in 2015 and beyond… You can bet on it.”
For much of 2014, markets accepted the Fed’s take on the U.S. economy and the future path of interest rates. But in the last two weeks – not so much. A few points here:
As of the date of the last Federal Open Market Committee meeting (September 17), futures contracts pegged the most likely Fed Funds rate as of the end of 2015 at just over 75 basis points (77.5 to be exact). This was lower than the Fed’s own consensus estimate of future rates, which the dot plot of “Appropriate pace of policy firming” in the minutes of the meeting showed to be 127 basis points. Still, it reflected the belief that the Fed would move several times to increase interest rates in 2015, with some possibility of getting to an even 1 percent before year end.
Since the beginning of October, the Fed Funds futures contract for December 2015 has repriced its expectations – the new point estimate is 43 basis points. Since the Fed typically moves in 25 point increments, this essentially points to a market belief that the Fed Funds rate will be less than 50 bp in 14 months. Looking at the different expiration dates for Fed Funds futures contracts, it appears that the market is discounting one move of 25 bp at the August 11-12 meeting. And then maybe – but just maybe – another 25 basis points at either the September 22-23 meeting or the November 3-4 meeting. And that’s it for rate hikes in 2015.
Looking out further to 2016, the disparity between market expectations and Fed projections widens considerably. Fed Funds futures peg the expected rate at 1.275%; the Fed’s “Dots” averaged 2.70% at the September Fed meeting. At the beginning of October – before all the drama in capital markets really hit its stride – Fed Funds futures were expected year end 2016 rates at 1.8%. No, not at the Fed’s projections. But closer than today’s price of essentially 1.3%.
When Wall Street Journal reporter Jon Hilsenrath asked Fed Chair Yellen at the FOMC meeting press conference what she made of the disparity between market prices of future Fed policy and the central bank’s own guidance, she said “I don’t frankly think that it’s completely clear that there is a gap”. That was in September, when the difference was smaller. Now, the gap presumably appears more obvious. She did go on to say that markets may simply have a different economic forecast than Fed members. That certainly does appear to be the case – in spades, actually.
The bet that markets are making is clear: global economic weakness and concurrent threats of cross-border deflation will temper the Fed’s ability to increase short term interest rates. Recent data from China to Germany to the U.S. support that thesis, and the weakness in capital markets this week buttresses that perspective even further. Equity investors know that periods of rising interest rates can engender price volatility. Now, Fed Funds futures seem to hold out the hope that the Fed will make only token moves to increase interest rates in 2015 and 2016. Some simple math shows that Fed Funds futures only expect 5 increases of 25 basis points apiece over the next 18 FOMC meetings. Not much headline risk there…
This analysis also solves the most-asked capital markets question of the last 7 years: “Do we want good economic news, or bad?” The answer is (for now) unequivocally “Bad news, please”. Equity markets want the Fed to back away from the table – the stabilization in stock prices over the last 2 days as Fed Funds futures repriced the cadence and amplitude of rate increases shows that relationship. So does the rally in the long end of the yield curve, for that matter. The yield on the 10-year Treasury note was 2.60% at the last FOMC meeting. It is now 2.15%.
To be fair to the poker analogy at the top of this note, the Fed never actually has to lose a hand. There is ample reason to believe that the FOMC will raise interest rates in line with their current projections. Just consider how weak the U.S. central bank’s hand is if there is a sudden economic shock to the system. Short rates at zero are like that Spinal Tap guitar amp that goes to 11 – once you are the extremes, there is nowhere else to go. Consider one example from recent history. At the end of August 2001, Fed Funds were 3.52%. They got to 1.00% in early 2004, and it was great that the Fed could play a role in stimulating the U.S. economy at a time of tremendous national need. What would happen now in a similar situation? The monetary toolbox is empty, and the Fed would very much like to fill it as quickly as possible.
In short, one side of this debate/card game is going to win, and one will lose. And it isn’t so clear who is bluffing. Also don’t forget the old maxim: the house always wins.
via Zero Hedge http://ift.tt/1rJ6M7n Tyler Durden