Fed Rate Shock?

So here we are, the final FOMC meeting of 2016 with the consensus forecast being for a 0.25% increase in the “fed fund rate.”

Whilst this commentary agrees with the expectation of an increased rate later today, it differs on the reason as to why and poses a thought that the consensus may be under-estimating the scale of the rise.

The rate increase will be nothing to do with Janet and her merry band of Fed colleagues, but more to do with how the market has already voted. On numerous occasions, including the August 2015 overview, “Revisiting the No 2’s,” observations has been made that central banks’ have never made a pro-active decision in their lives, only re-active. The FOMC base- rate, or any other central bank rate come to that, has followed the trend of the 2-year Sovereign yield, not the other way round:

14-dec-16

 The first chart compares the US base-rate, US CPI and the US 2-year Treasury Bond Yield. You can see how the base rate followed the 2-year yield, up or down, over the past decade, and regardless of the annualised CPI inflation rate, which many analysts’ think decisions are made on. As can also be seen, CPI is a “lagging indicator.”

On a monthly data basis 2-year yields have soared by 480% since their August 2011 low of 0.2% to the current 1.16%, whilst there has only been the one fed-funds hike from 0.25% to 0.5%. Although a little difficult to see from the chart, for the FOMC to catch-up with the 2’s, it requires a further 0.5% rise to 1%, not the 0.25% expected.

This of course would be a shock to the market, which brings us to the second chart, this time comparing the 30-year Treasury bond yield, which is of far more importance as it is to this that most US mortgages are aligned. It has been inverted, to better show it correlation to the strong sister of the US stock-indices, the Dow Jones Industrial Average, the Dow.

14-dec-16-2

As can be seen from the chart, there has been a loose fit between the two variables, until just recently that is, where they have diverged with yields spiking higher, along with the Dow, which normally falls as interest rates rise.

So what does this mean?

It’s fair to say that sentiment indicators for increased bond yields are a little ahead of themselves, so there may be a brief retracement before they move higher yet. Likewise with the Dow, where certain sentiment gauges have reached 20-year record bullish extremes, hence the Dow should be set for a decent fall.

If the rate increase is for 0.5% rather than 0.25%, there could be shocks all round.

 

 

 

 

 

 

 

 

 

 

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