Do Not Challenge The Fed With 4% Fed Funds Expectations

One by one the rates experts came out after last week’s astounding Non Farm Payrolls to revise their expectations of when the Fed is expected to hike rates after the taper ends in October.

Goldman’s Chief Economist Hatzius brought forward his estimate for the first Fed hike to Sep 2015 and for the Fed Funds rate to rise back to 4% by 2018.  This is nothing as aggressive as Bank of Tokyo’s expectation for the Fed to hike by Mar next year.

Current market odds are 50-50 for the Mar 2015 hike with most consensus centreing in Jun – Sep next year.

Yes. The hikes are coming but the bond market is hardly fazed. This time last year, the calls were all for hikes to start in mid 2015, if you scroll through the headlines from a year ago, implying that nothing has changed. Even the 10Y US treasury yield has not changed from a year ago, at 2.60%.

Things have changed. The Fed is going the way of forward guidance and the market is right in the heart of one of the fiercest corporate bond and stock market rally in history and no one is really thinking about the 4% in 2018 because it does not look in any way logical or probable, not especially after last night’s FOMC minutes that was recorded pre Non Farm numbers.

The most important statement for us on investor complacency.

However, participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks in their investment decisions. In particular, low implied volatility … as well as signs of increased risk-taking were viewed by some participants as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy. They agreed that the Committee should continue to carefully monitor financial conditions and to emphasize in its communications the dependence of its policy decisions on the evolution of the economic outlook; it was also pointed out that, where appropriate, supervisory measures should be applied to address excessive risk-taking and associated financial imbalances. At monetary policy needed to continue to promote the favorable financial conditions required to support the economic expansion

I particularly like WSJ’s summation of this to read as “We don’t know what we’re doing so how can you be so sure?” http://blogs.wsj.com/economics/2014/07/09/divide-on-inflation-views-growing-at-the-federal-reserve-minutes-show/

Needless to say, bonds rallied, stocks rallied, gold rallied and the USD sold off and the complacent investors win.

The forward guidance formula is perfect in that the Fed is not allowed to raise rates at any time before forewarning the markets with ample time lag. They have indicated that such a warning will come at year end, after Taper completion in October which gives us many good months of policy inaction.

Many a retail investor  would have missed the fact that the 3 year US note has touched a 3 year high in yield, breaking 1% last night before closing at 0.96%.

3Y UST Yield

This is a highly significant trend that insitutions are catching on, as traders price in a 78% chance of a Fed hike by Sept 2015 and has pushed the market further out into the longer end of the yield curve.

It probably does make a lot of sense not to hold on to the shorter tenors given the funding rate expectations.

I have prepared a table to give folks a rough idea of where 3M borrowing rates will be for SGD and USD in the future.

3 month SOR and USD rates

The SGD rates are projected using SOR and not SIBOR as it is difficult to find a credible SIBOR curve above 1 year. We can thus assume that SIBOR will trend with SOR.

It is comforting that the long term US yields are still holding to their 1 month low which could be a function of the record market shorts in those bonds which is coupled with expectations of shrinking supplies (as the US reduces their deficit) into the future. http://www.bloomberg.com/news/2014-07-06/bond-anxiety-grows-in-1-6-trillion-repo-market-as-failures-soar.html

I suspect the some would be happy if the complacency in the marketplace holds, long enough for them to continue unwinding their positions and pass on the risks to others without disrupting the momentum.

How should we read the situation and the Fed ?

One step at the time. Preparing for the rate hikes next year is a very good idea because they have already said so. As for the long end bonds, equities, commodities and such, it would be foolhardy to challenge the Fed and their ultimate and elusive quest for a monetary policy “needed to continue to promote the favorable financial conditions required to support the economic expansion”. Whatever that means ?