The Fed may surpise itself at lift-off…

‘New Keynesian (thinking) is the dominant school in Macroeconomics…’ Noah Smith, Bloomberg, 16 July 2015

Waking up to this pronouncement nearly drove me to suicide. When you work in the financial markets, where market prices almost instantaneously reflect new information, one tends to hope that policymakers operate within the same market realities. The majority of policymakers are New Keynesians (NK’s) which means they do not believe that their future policy actions have already been impounded into asset prices.

A case in point is the long awaited Federal Reserve ‘lift-off’, which is when the Fed raises the short term interest rate for the first time since 2006.  This event may be in September or sometime next year.  Fed policymakers,  dominated by NKs, want ‘lift-off’ to trigger the following chain of events: interest rates rise across the curve, causing marginal investment plans to be shelved, and therefore taking the heat out of a booming labour market which in turn averts a surge in inflation.  A text book response out of Dornbusch and Fischer, that is sadly at odds with market realities…(1)

The Fed is going to be disappointed.  This is because the yield curve is already reflecting expectations of an aggressive Fed. To provide some context for what the market is currently pricing into the yield curve, consider the following,

• –  the market is already paying 0.75% for cash in one year’s time and 1.5% for cash two years forward.  The Fed must exceed these expectations for short term rates to rise

My guess is that Fed President Yellen will go to great lengths to emphasise that the Fed is acting dovishly rather than aggressively.  But since the market is already pricing in quite aggressive tightening, any indication that the Fed will pursue (i)  smaller interest rate moves (15bp instead of 25bp for instance) , (ii) slower interest rate moves (hiking at alternate meetings), or (iii) capping potential interest rate moves (some indication that the Fed has a target at which they will stop), will wind up being positive for bonds and actually lowering interest rates.

In other words, since current market expectations are anticipating an aggressive Fed, the market surpise is the realisation of a dovish Fed.  This would trigger a lower risk premium leading to lower interest rates at longer maturities and a ‘bull flattening’ of the yield curve.  Surprise! This is exactly the opposite of what the Fed wants.

Footnote

(1) To be fair, the Fed likes to think that they have telegraphed effectively to the market what they intend to do.  The market, on the other hand, is suspicious and therefore demanding a high risk premium.