Gavekal Capital: Moving the Goal Post

Tuesday, October 14, 2014

Moving the Goal Post

It seems as if investors and the Federal Reserve woke up on October 1 to realize that a strengthening US Dollar was  undoing a lot of the reflationary work that had been achieved during QE.  Once the internal price of money (interest rates) hits zero, the only thing left for the central bank to do is change the external price of money (the exchange rate).  So, the exchange rate is of critical importance for a central bank that finds itself at the zero lower boundary with inflation undershooting.

It was just a month ago, in mid-September, that the bond market was selling off in expectation for the Federal Reserve to begin raising interest in the first half of 2015, taking rates to 1.375% by the end of 2015 and 2.5% by the end of 2016.

Now, it seems the Fed has woken to the potential impact of a stronger USD, set off by the bond market taking breakeven inflation expectations embedded in 5-year UST below the critical 1.5% and 10-year UST below 2%.  Recent speeches by Fed officials suggest they are trying to temper tightening expectations.  Since the fed funds future market was way behind the "directed" path of rates offered by the Fed, the market clearly didn't give a lot of credence to hawkish projections for rates over 1% at the end of next year.  But, it is interesting now to see the bond market go a few steps further in expressing its collective lack of trust in the Fed's words.

In the charts below, we compare the 10 year UST bond to rate projections based on the December 2015 fed funds futures and the December 2016 contract.  In the first chart, we can see that now the market expects fed funds to be 50bps at the end of 2015.  That suggest just one rate increase of 25bps between now and the end of 2015.  In the second chart, we can see that the market expects the fed funds rate to be only 1.44% at the end of 2016.  Since just a month ago, the Fed was telling us that rates would be 1.375% at the end of 2015, the market appears to be saying the Fed's rate trajectory is off by close to a year.  That's really moving the goal posts!