Guy Haselmann: How Far Behind the Curve is the Fed, Anyway?

by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM

I responded to an email question this morning with the note below.  Since I believe it has some reasonable discussion points, I thought I would forward it to you in place of a daily commentary note.

-Guy

The Fed has purposefully tried to engineer a later lift-off beyond what it normally should have been  -- due to the extent of the crisis.  However, they risk losing credibility as the market is questioning just how behind the curve they are. A growing group of investors is worried that the Fed is blind to the aggregating risks to financial instability.

The interesting contradiction is that the market believes the Fed should have tightened already, yet interest rate futures have priced “lift-off” probabilities beyond September.  This  incongruity in interest rate futures stems from the market’s perception that the majority of  FOMC members are Doves who rely too much on models and will thus stay accommodative.  The ZLB simply does not afford the Fed the option of rising too soon or they believe they will undo much of the progress that they made (and would have no bullets to fix that mistake).

Unfortunately, Fed models are incapable of measuring extent and costs of financial instability – something Mester admitted and emphasized last week.

The FOMC likely recognizes that there will be a ‘market reaction’ when rate “lift-off” finally arrives, but there are many (including myself) who believe the Fed is under-estimating the degree of that ‘market reaction’. Fed worries are suppressed, because they believe they have “macro-prudential” tools:   a talking point that few in the market have understanding what it really means.  Regardless, those tools do not prevent market disruptions, but merely help to pick up the pieces once the market’s reaction gets bad enough.

The front end of the bond curve needs to price in a Fed that likely to hike in June.   This is occurring (after today’ employment report) and thus shrinking the divergence between the Fed warning about June “lift-off” and the markets skepticism.

The curve is steepening today as long maturities are battling between two cross winds (explained in a moment).  Yet, the upward pressure on long yields could be short lived to this week and early next (supply), while the downward pressure on yields may be a slower moving and on-going theme.

Yields are being pressured higher by a historically large corporate issuance calendar (above $60 billion this week alone) and the perception that the Fed is behind the curve -- particularly after the ECB’s action and numerous other global central bank easing moves in 2015.

On the other hand, yields are being kept lower than they would otherwise be, due to low global bond yields and an appreciating US dollar trend which makes Treasuries very attractive to foreigners on a relative basis.  In addition, yields are  low due to hoarding of long-date securities by central banks which is creating a shortage of high-quality highly-rated sovereign bonds.  Regulatory rules have also required banks to hold more of them.   Therefore, it is difficult to price the value of long-dated Treasuries when they have qualities of a commodity whose demand is arguably greater than the supply.