As I write this, US Federal Reserve Chair Janet Yellen and the Fed’s Board of Governors are ensconced in another two-day meeting. As with past sessions of the Federal Open Market Committee, they will make a statement at the end. That statement will either move markets or bore them, but as a professional investor I will be waiting for exactly one thing: certainty about the path interest rates will take.
You’re supposed to laugh at that line. It’s more likely I’ll be tapped to be the new lead singer of One Direction than the Fed will tell us exactly what it’s going to do. But I’d settle for Yellen and company just narrowing the range of projections they’re offering a little bit.
I was privileged to be in attendance at the 60th Annual Financial Analysts Seminar (FAS) last week in Chicago, where PIMCO’s Marc Seidner got straight to the point in his presentation: The dots aren’t adding up. His first slide came from the Summary of Economic Projections of the most recently released Federal Open Market Committee meeting minutes. It’s a bunch of dots. Here it is:
Appropriate Pace of Policy Firming: Midpoint of Target Range or Target Level for the Federal Funds Rate
Source: The US Federal Reserve.
According to Seidner, each dot shows where a voting member of the committee expects rates to be at the end of the calendar year in question.
You See the Problem, Right?
If this chart is being offered as an answer to the question, “What do you guys think is going to happen with interest rates over the long term?” the answer that we are being left with is “lol, I dunno.”
Just think about it. The span of projections given for the end of 2016 range from a little under 50 basis points all the way up to more than 2.75%. The US 10-year Treasury bond closed Monday yielding 2.23%, which means there is literally an entire 10-year Treasury bond’s-worth of yield between the low and high end of the forecast range.
It’s convenient that the same degree of uncertainty doesn’t exist about “longer term” interest rates: We are clearly being told to think of them as gravitating towards the 3.25%–4.25% range. But anybody who has spent time in investment markets can tell you that the long term can take a long time to materialize.
The Fed seems to be saying the same thing.
So to practitioners who are active in the market now, there’s a straightforward question: What do you do? My colleague Jason Voss, CFA, has drawn attention to “The Little Worm That Is Destroying Capitalism,” but we need to do more than stay away from companies with lazy capital budgeting processes.
We Need an Interest Rate to Value Stuff With
And we don’t really have one. Or at least so it seems. Most investors should still be using discount rates that reflect what they expect to see over the lifetime of their investments, and I really hope that most people making active allocations have a time horizon of more than 18 months in mind. So perhaps it’s worth examining your process a bit if you find yourself wondering when Janet Yellen is going to fix your discounted cash flow (DCF) model.
But with that said, the market has a mind of its own. And this Federal Reserve Board’s approach to normalizing policy may make it a more productive strategy than usual to pay attention to market-oriented forecasts instead of trying to read the tea leaves too closely. Indeed, Jim Bianco of Bianco Research argued in an earlier presentation that the Fed is unlikely to raise interest rates until the hike is priced in. To make our lives simpler, he suggested that we all check the CME Group’s FedWatch and go about our business. In case you’re wondering, yesterday the near-month contract was trading with an implied 0% probability of a rate hike, albeit on close to no volume. The market right now has a 91% probability on a hike, but that may be static as trading in the contract comes to a close.
But the importance of the Fed seemed straightforward to all who were in attendance at the FAS. At least five of the sessions focused on the path that this esteemed group of 12 technocrats would chart for the global economy. But at least a part of me wonders how much agency they have in the matter. Speaker Vivian Lau, formerly of Serengeti Asset Management, argued that 70% of central banks around the world are easing right now. We (as the market) are focused on the one in Washington, DC, though.
Is that because it’s really the most important? Or just because it’s the closest?
I have to wonder if it’s the latter. Though the phrase only appears once in the most recent set of minutes, Fed watchers have stressed that the bank is likely to remain “data dependent” in setting the future course of policy. What that means is anyone’s guess. It sounds great to concentrate on the data. and clearly all analysts should have no problem with data-driven decision making.
But one has to wonder if a data-driven decision might be a means of distracting the market from a more insidious truth: Perhaps the data are truly in control. Maybe, despite the implied power of the Fed, the Federal Open Market Committee is no more able to raise the prevailing rate of interest than I am able to levitate.
We will see. One thing is for sure though: the quote of the FAS goes to Holly Huffman of JP Morgan, who relayed her hope that the Fed would hike rates at the upcoming meeting. Why?
“So we can start talking about something else.”
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