Fed Forward Guidance

The financial markets have come full circle since 2008.  2018 is the first time in 10 years where market consensus is pricing in a hot economy and higher inflation.  Just looking at the Eurodollars pricing LIBOR at 3.00% in 2020, assuming a TED spread of 40 bps, You are pricing in a Fed funds rate of 2.50-2.75%, which would mean 4 more rate hikes by 2020.  The Fed has come out and said that it believes the long term neutral rate is 2.50-2.75%.  This the same Fed that thought in 2014, when the US economy was stronger than it is now, that the long term neutral rate was 3.75%.  So that gives you an idea of how wrong the Fed has been in the past. 

In my opinion, a Fed funds rate of 2.50-2.75% is the best case scenario, not a base case scenario.  I would put the base case scenario at 2 more rate hikes this year, taking Fed funds to 2.00-2.25% by year end, completing the cycle.  After that, I expect the cumulative effects of higher interest rates to show up in the economic data, which will scare the Fed into pausing, and eventually easing when the economy rolls over.  The Fed already is starting to come out a bit more dovish than they were in March, such as considering subtle steps such as raising interest of excess reserves at a smaller increment than Fed funds rate at the next meeting, or changing their inflation target into a symmetrical target, tolerating as much time above 2% as it was below. 

Forward guidance has misled the market into believing the Fed is omniscient and can predict the future.  They have been wrong about the rate hike path since QE started.  When QE was initiated in 2009, it was assumed to be a fairly short term emergency program.  The Fed managed to drag it out for almost 5 years, out to the end of 2014.  In December 2015, when the Fed got off the zero bound and raised 25 bps, the Fed forward guidance called for 4 rate hikes in 2016.  There was only one.  Finally in 2017, the Fed finally followed their script, only this time, it was less ambitious, with 3 rate hikes and the start of QT considered a tightening step, letting them skip a hike at a conference call meeting. 

Now that the Fed is following its unambitious 75 bps/yr rate hiking cycle, all of sudden the market believes the Fed will actually keep to their guidance, when they've been fooled so many times before.  Partly this is due to the stock market's resilience in the face of 10 year yield around 3%, and also due to the optimism about the economy.  But higher borrowing costs slowly work to weaken growth.  Loans and bonds are usually done at a fixed rate, and a big portion of them don't mature for several years.  So bit by bit, as loans and bonds are renewed and rolled over, the fixed rates are set at a higher level, not a lower level like they were for most of the last 10 years.  That makes interest payments higher, offsetting a lot of the tax cuts or even overwhelming the tax cut effects. 

The 3Ds: debt, demographics, and deflation should really be just 2Ds: debt and demographics.  Deflation is the boogieman that is made up by central bankers who need an excuse to print money and pump up the financial markets.  In the long term, debt and demographics are significant.  Japan is the obvious model for this, with easily the highest government debt to gdp ratio of any country in the world, and probably the oldest demographics as well.  They are stuck at zero and their bond market is dead.  Europe is not too far behind in the debt and demographics department.  And while the US doesn't have the same aging demographics and has higher population growth, it pales in comparison to the US of the 1940s-1990s, when population was growing strongly, and the nation was relatively young. 

We are seeing some European jitters as PIIGS debt yields are surging higher.  Italy 10 yr spiked above 2.50% and EURUSD is at 1.166.  This seems like a 3 day weekend risk off selling, not anything fundamentally new.  Europe will stay cobbled together until Draghi's term is over.  So there shouldn't be any major problems till Germany gets their guy as ECB president, at which point, the QE option will likely be taken away which would be punishing for the PIIGS.  But that won't happen till late 2019, so nothing to worry about now. 

The SPX has been quite resilent in the face of these European headlines, a stronger dollar, and with 10 yr yields back below 3%, I expect another attempt to break out above 2740.  If Powell comes out dovish at the June Fed meeting, that could be the last hurrah top before the move back down to 2600.  Right now, it looks like its best to wait to get short SPX.  I don't expect the market to runaway to the downside (or to the upside) anytime soon.