By Brian Jacobsen, Chief Portfolio Strategist
- Today’s Federal Open Market Committee meeting (FOMC) minutes reflected a lively debate about when the Federal Reserve (Fed) should start raising interest rates.
- I think the Fed is likely to stay the course with the taper, but will use its forward guidance to influence investors’ expectations about the future path of interest rates more extensively.
- One source of data I look at for gauging the effectiveness of Fed communications in influencing market movements is the 30-day federal funds futures market.
- I believe an analysis of how the markets have responded in recent months to the implied federal funds rate shows that the Fed isn’t going to raise rates prematurely, though one or two members may find that preferable.
The minutes from the January FOMC Meeting reflected more debate about what the Fed should do in the months and years ahead than I’ve seen in a long time. Most of that was driven by the new voting members, Richard Fisher and Charles Plosser, both of whom are hawkish and critical of what the Fed has been doing since the financial crisis began. The minutes do not call members out by name, except when they vote, but it is likely these two argued that the Fed should begin raising rates relatively soon—views that will not likely win many converts on the FOMC.
While the policy statement released on January 29 did not mention the travails in the emerging markets, the minutes made many references to them. The Fed is concerned about the spillover effects of changes in U.S. monetary policy on other countries, but it is really only going to change what it does if those spillovers turn into splash-backs on the U.S. growth or inflation outlook. As far as the outlook for growth and inflation, inflation is still running too low for most Fed members’ tastes. Growth, however, is viewed as likely to pick up, with the December and January data being affected by the weather. The key paragraph in the minutes reads as follows:
Business contacts in many parts of the country reported that they were guardedly optimistic about prospects for 2014. While inventory investment would likely come down from its recent unusually high level, participants heard more reports that the business sector was willing to increase spending on capital projects. A number of factors were cited as likely to support such an increase, including the high level of profits, the low level of interest rates, a reduction in policy uncertainty, the easing of lending standards, and the large holdings of liquid assets by corporations.
I share the Fed's optimism.
Reserving the right to slow down the taper
The Fed is likely to continue its tapering plan of cutting monthly purchases of securities by $10 billion at each meeting, wrapping up the purchase program sometime in the fourth quarter of 2014. The only way the Fed will likely change the trajectory of the taper is if there is a notable (that is, really bad) change in the data on labor market or inflation conditions. I think the Fed is inclined to stay the course with the taper but reserves the right to slow it down rather than speed it up. The tool the Fed wants to use more extensively is its forward guidance—that is, the way it communicates to the public what its intentions are for changing the target for the federal funds rate.
Forward guidance is a tricky thing. It involves the Fed trying to manipulate what people think the Fed will do, and when it will do it. That’s been a tough game for the Fed to play over the past year.
One source of data I look at for gauging the effectiveness of Fed communications is the 30-day federal funds futures market. This is a market that trades contracts that have payoffs tied to the 30-day average federal funds rate for any given month in the future (up to 36 months out). For example, a contract for June 2015 shows a payoff based on whatever the average federal funds rate will be in June 2015. This gives useful insight into what traders think the federal funds rate target will be in any given month. Of course, normal swings take place in these markets, and trader demand and supply depends on factors other than what the Fed may do in that month. But looking at this futures market gives us a pretty good guess at what the Fed may do.
How futures contracts could help predict the first increase in the federal funds rate
What has the federal funds rate futures market been telling us? To find out, I looked at the average federal funds rate implied by the federal funds rates futures for the months from December 2014 to February 2016, as traded from the beginning of 2013 to February 18, 2014. To see when the futures contracts were predicting a first increase in the federal funds rate from 0% (0 basis points [bps; 100 bps equals 1.00%]) to 0.25% (25 bps), which is likely going to be the magnitude of the first rate hike when it happens, I identified the first contract month with a rate within one standard deviation of 25bps (see table below for the month of the implied first rate hike and key dates). I did this because a variation in the prices of the contracts is natural and not always directly related to what people think the Fed may do. For example, December 2014 contracts have a standard deviation of 2 bps, with the standard deviation increasing out to the February 2016 contract to 5 bps. I was looking for the point at which the implied rate got “close enough” to the threshold of a 25 bps rate increase. For more about the use and limits of the federal funds futures market as a forecast of Fed policy, see Federal Funds Futures, Risk Premium and Monetary Policy Actions in Applied Financial Economics by F. Nourzad, J. Calhoun, and A. Kurkiewicz (2012).
second-quarter 2015 target for a rate hike
|The X indicates month of market- implied first rate increase||Dec-14||Jan-15||Feb-15||Mar-15||Apr-15||May-15|
|2-11-14 (Yellen testimony)||X|
|1-29-14 (policy statement)||X|
|1-8-14 (December minutes)||X|
|12-18-13 (policy statement)||X|
|10-30-13 (policy statement)||X|
|10-9-13 (September minutes)||X|
|6-19-13 (policy statement)||X|
|5-22-13 (Bernanke testimony/May minutes also released)||X|
|5-1-13 (policy statement)||X|
|3-20-13 (policy statement)||X|
Traders were apparently believing the Fed would do its first rate increase before 2015, up until the March 20, 2013 policy statement from the Fed. Suddenly, the implied first rate increase pushed out to February 2015. By May 1, 2013, with the FOMC policy statement, the market was implying the first rate increase would be May 2015. Then, on May 22, Ben Bernanke testified before Congress, revealing that, yes, the Fed would eventually begin to slow the pace of its asset purchases (the taper). After his testimony, the first rate hike was moved up to before January 2015. It stayed there until the September 18, 2013 policy meeting, at which the Fed didn’t start its taper, despite the mounting expectations that the taper was imminent. The first rate hike moved from January 2015 to May 2015 with the December 18, 2013 FOMC statement, when the taper actually did begin. This is because the Fed tweaked its forward guidance, effectively trying to offset any perceived tightening from the taper. This is when the Fed said that crossing the 6.5% unemployment rate threshold wasn’t likely to push the Fed to raise rates. It would take much more, like projected inflation running hotter than 2.5%, to get the Fed to tighten. The first rate hike moved up to February 2015 with the release of the FOMC minutes from the December meeting, but it has since moved back out to May 2015.
At the February 11, 2014 testimony of Chair Yellen before Congress, she reiterated that the target rate would stay low, possibly for years. However, the implied rate in the federal funds futures market suggested a second-quarter 2015 target for a rate hike.
How the markets respond to the implied federal funds rate shows that the Fed isn’t working against investors
Why does this matter? The Fed isn’t likely to tighten monetary policy unless it thinks the economy can handle it. Even if the Fed isn’t encouraging liquidity flow through asset purchases, it isn’t working against investors. From October 2013 to December 2013, when the implied federal funds rate went down (indicating expectations of looser monetary policy), the S&P 500 Index went up (see chart below, where the right vertical axis is inverted and shows the implied federal funds rate). These two data series started parting ways after the December FOMC meeting, perhaps showing that investors were OK with the taper knowing it reflected Fed confidence in the health of the economy. But, when the S&P 500 Index started heading down on January 22, the implied federal funds rate also went down. This likely showed a flight to safety by investors and an expectation that the Fed may have to keep rates low for longer than previously thought.
If you need reassurance that the Fed isn’t going to raise rates prematurely, look to the federal funds futures market. With uncertainty surrounding whether the economic slowdown in December and January is simply weather-related or whether there is more to it, we could see a return to the correlation of October to December, with the stock market moving up or down, based, in part, on shifting expectations of when the Fed may first raise rates. I think the Fed wants to push that first rate hike out further into the future, not pull it in. That’s one reason I stay bullish on equities for the balance of the year.