The Credit Market Cuts Rates While the Fed Pretends to Hike
On December 16, 2015, the US Federal Reserve raised interest rates for the first time in nine years, claiming that the US economy was strong enough, and the threat of higher inflation real enough, that higher rates were needed now.
The Credit Market Cuts Rates While the Fed Pretends to Hike
On December 16, 2015, the US Federal Reserve raised interest rates for the first time in nine years, claiming that the US economy was strong enough, and the threat of higher inflation real enough, that higher rates were needed now. The Fed also released projections (the infamous dot-plots) which indicated that the market should expect another four hikes in 2016.
The Fed no doubt thought that a market expecting tightening would tighten all by itself. It is a theorem of central banking that the market will expect the future that central bankers pre-ordain, take their direction and do the work central bankers want done. But not this time.
Market rates are not moving towards normalization. They are pricing in the reverse -- more accommodation. The proof is in deep markets such as Eurodollar Futures which, as Jeffery Snider of Alhambra Partners points out, has actually priced in the equivalent of four rate reductions since the last Fed meeting, the exact opposite of the Fed's predictions.
The above is Snider's graph of the price of the June 2018 Eurodollar contract going back to May 15, 2015. Note that from just after the hike in the Fed Funds rate, the implied interest rate on this instrument has dropped 103 basis points as of last Thursday's close (February 11). Snider uses the June 2018 Eurodollar Futures contract because it's close enough to the front end to be significant in terms of monetary policy but far enough out to be representative of intermediate economic expectations.
Note that the Fed Funds rate is actually a little used fiction, an illiquid bench mark with few transactions connecting it to the broader credit markets. On the other hand, the CME reports Eurodollar Futures open interest of 416,955 contracts at $1mm each, totalling $417 billion in gross contracts written. So, as Snider concludes, "Yellen ordered a quarter-point hike in federal funds and received instead four of them in reverse across the much more significant and important eurodollar complex." (February 11, 2016)
These facts lead us to make three observations: (1) The credit market clearly does not believe the Fed will normalize monetary policy; (2) The credit market does not believe the Fed's projections of a stronger and inflation-prone US economy; (3) Fed credibility is fading fast and a reversal of Fed policy back to additional accommodation may not be able to rally the stock market the way many believe.
Our conclusion? Markets are telling us to buy gold. There is nothing like a loss of confidence in central banking to put a bid under gold.