Fed Expectations – Surveys and Markets

The Federal Reserve meets in a month.  How should investors measure expectations? 

We can take a page from the Fed’s play book itself.  It has identified two ways to measure inflation expectations.  There are market measures, like the spread between inflation-linked bonds and conventional bonds, or break-evens.   In addition, there are surveys, like the University of Michigan’s survey that ask respondents specifically the rate of inflation they expected in both the short and long-terms.

The Federal Reserve has placed more emphasis on surveys, which show inflation expectations remain anchored.  The market-based measures have softened.

Similarly, there are survey and market-based measures of expectations for Fed policy.  The graph below includes the results of the monthly Wall Street Journal survey.  The survey for the most recent bar was conducted following last week’s employment report.   There are also market-based measures such as the Fed funds futures and the Overnight Index Swaps (OIS).  

There is a similar discrepancy between the measures of Fed expectations as there is with inflation expectations.  The WSJ survey shows high expectations for a hike next month while market-based measures show less conviction.

The Wall Street Journal survey of 60 business and academic economists found 82% expect a hike next month.  This is unchanged from July’s survey and up 10 percentage points from June.  A December hike is thought more likely by 13% of the respondents, down from 15% in the July survey. Only one economist thought the Fed would wait until next year to hike rates.

Interestingly, the survey found that 69% of economists thought that the risk was that the Fed would wait too long to raise rates.  The others (31%) thought the risk was that the Fed would move too soon. The split last month was 71% to 29%.

Market-based measures are considerably less convinced.  The September Fed funds futures contract is pricing in a little less than a 60% chance of a hike.   Some assumptions have to be made, and the different assessments reflect these different assumptions.  The contract settles at the average effective Fed funds rate for the month.  Unlike in the past, the current policy targets not a fixed level of Fed funds, but a range.  Currently, that range is 0-25 bp and the effective Fed funds rate has averaged 13 bp over the past 100 days.  Note that the Fed funds effective rate on Fridays, also count for Saturday and Sunday.  This month the effective Fed funds rate has averaged 14 bp and this week it has ticked up to 15 bp, which incidentally is the highest since Q1 13.

Under the assumption that effective Fed funds rate average 14 bp in September prior to the FOMC meeting, and then average 38 bp after the hike, the effective average for the month would be 24.4 bp. September contract is currently implying an effective average of 19 bp.  The higher we assume the effective Fed funds rate average, the smaller the percentage of a hike has been discounted.

If we assume that the effective Fed funds averages 15 bp in the first 17 days in September, before the Fed decision and then 38 bp for the remaining 13 days of the month, the effective average for the month is 25 bp.  There would be six bp gap between the current implied yield and the “fair value” under the conditions of a rate hike.

In trying to decipher what the Fed funds futures market is discounting, some try to incorporate implied option volatility, but we do not find this particularly helpful.  The options are not always actively traded, and there is often a relatively large spread between bid and offers.   In any event, one can see through this exercise that assumptions are critical and that the Federal Reserve’s new target range for Fed funds increases the degrees of freedom.

That said, the OIS market appears to line up well with the Fed funds futures.  This offers another market-based measure that indicates investors/traders are not as convinced as economists that the Fed will raise rates next month.

Many who push against a hike next month, cite the IMF’s recommendation that the Fed holds off until next year, the volatility of the stock market, and China’s move.  In some ways, these developments may very well boost the risk of a Fed hike in September on ideas that Fed officials may feel the need to show that it keeps its own counsel.  Fed policy is not set by the IMF, Beijing or institutional traders that dominate the US equity market.

Part of the logic of the timing of the PBOC’s move this week may have influenced by trying to get ahead of a Fed move.  The precedent is what the Swiss National Bank did earlier this year.  Its decision to lift its cap on the franc looks to have timed to get ahead of the ECB’s asset purchases plan.

Moreover, decision-makers like to maximize their options.  A failure to hike rates next month would mean that there can only be, within reason, one hike here in 2015.  In June, a slight majority of Fed officials still saw two hikes as being appropriate.