Monday, December 21, 2015

Digesting the Fed rate increase - the dot frenzy





The Fed raised rates, no surprise. The Fed acted, "Move along - nothing to see here". This was the one of the most telegraphed Fed action in history, but what now? Market reaction is usually not associated with the headline or what was expected but what was occurring under the surface buried in the fine print. This FOMC meeting was all about the dots and 2016 forecasts. The dots of what the Fed is expecting in its Summary of Economic Projections (SEP), what the market is expecting in the Fed funds futures, what forecasters are thinking, and what may actually occur. Money will be focused on the rate path now that the first increase is in the books.

The dot plot suggests that there will be four 25 bps rate increases in 2016.This will be over 8 FOMC meetings in year. The Fed funds futures may be a little more pessimistic on these hikes. Economists are more consistent with Fed expectations, but there is a strong minority which we can call the "one and done" school. Certainly, listening to Chairman Yellen would suggest that this increase was dovish-lite with the key words being gradualism and data dependent. Listen closely and you could believe in "one and done"

What is clear is that the Fed is worried about the plumbing in the money market system with reverse repo lines being raised to $2 trillion if necessary. There is the fear that it may take a lot of work to keep repo and the Fed funds in the middle of the 25-50 bps range. There just is a lot of money outside the banking system that controls rates so the Fed has to use a lot of fire power to move rates. In fact, more investors are going to focus on the Fed balance sheet in 2016. We are back to looking at the quantity theory of money through the Fed balance sheet. This is where the real monetary expectations will be focused.

There will now be a more focus on the real economy and data dependency and away from the hyper-sensitivity of Fed watching. We expect that the six to nine month Eurodollar futures will be one of the most active places of trading in all of financial futures. The bets on future rate hikes will be the big trades for the new year and where every hedge fund focused on fixed income will be placing their  money. Option activity may set records and economic data will be closely linked with spread trades in ways that we have not seen for years.  The data dependent gradualism of Yellen is leaving the markets uncertain. The reaction may be slow with holiday and year-end but the when traders start really thinking about market divergences, the front-end of the yield curve will be the place of focus. 

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