Thursday, September 21, 2017

Fed Dot Plots

Looking at the Fed dot plots for September, I find it interesting how the long run projection is still at 2.75%, albeit down from 3.00% in June.  What happened in 3 months that would cause a long run projection of interest rates to go down 25 bps?  Nothing happened, other than the Fed throwing the bond market a bone, to try to keep the bond vigilantes at bay, while they announced balance sheet tapering. 

Everyone with any money on the line knows that the Fed dot plots are a running joke.  They have consistently inflated future interest rate projections, only to bring them down in drip drip fashion.  Is that the Fed's way of increasing optimism about future economic growth?  I don't know if the Fed is being dishonest, or if they're just incompetent.  Probably the latter. 

If you look closely at that dot plot, there is one guy who keeps the projection at the current Fed funds rate level, at 1.00-1.25% till end of 2020, but somehow manages to put the longer run projection at 2.25% or higher.  I know this is Neel Kashkari, the super dove.  He's a bit controversial, and an attention seeker, but he's got the best forecast of them all, which isn't saying much.  Although his longer run projection seems way too high, unless he's thinking something like 2040 as longer run. 

The eurodollar market is pricing in 3 rate hikes over the next 3 years.  That would put the Fed funds rate at a 1.75-2.00% range by September 2020.  I feel like that is a bit ambitious considering that when pricing in future interest rates.  If you consider that there is a decent chance that the economy could enter a recession within the next 3 years and the Fed could cut rates, then there should be a lot less than 3 rate hikes priced in over 3 years.  Remember, you must come up with a probability weighted average of all possible interest rate scenarios, not just the mostly like one. 

The median Fed dot plot is between 2.75-3.00% by end of 2020.  Do they realize that when GDP growth went from 2.9% in 2015 to 1.5% in 2016, they stopped rate hikes dead in its tracks, and were scared stiff.  The economy doesn't even need to go to recession for them to stop rate hikes.  It just needs to slow down to under 2%.  Considering the heavy debt load, low productivity, and low population growth among the developed economies, it is more likely that growth will slow down from here over the next few years, not pick up. 

Add to that Trump's inclination to choose a dovish Fed chairman because he's a low interest rate guy.  Therefore, you have a bond market that is mispriced.  And a Fed dot plot that is even more wrong.  Now I could be wrong and the global economy could have a huge boom and the S&P could become a giant bubble, but that's not likely given the data.  There is always some uncertainty in predicting the economy and the financial markets, which is why there are mispricings in market.  This game is about probabilities, and it is the difference in how market participants weigh the likelihood of various scenarios which provide the long term opportunities. 

The S&P didn't disappoint yesterday.  Once again, it found a way to bounce back after the hawkish Fed statement.  And do it in a non-volatile manner.  It has proven its boring nature AGAIN.  Just untradeable.

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