FOMC Preview: The Long and Short of It

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FOMC Preview: The Long and Short of It

With the Federal Open Market Committee meeting concluding this Wednesday and Fed Chair Powell’s press conference the same day, today we’ll look at where markets think policy rates might go and also take a long-run look at how 10-year Treasuries trade during economic recovery.

Item #1: Fed Funds Futures

First, the CME FedWatch tool shows that the odds imbedded in 2021’s Fed Funds Futures contracts continue to put very low odds on a policy change this year. These probabilities have banged around quite a bit over the last 2 weeks, but currently stand at just 4 percent odds.

Second, as we go out through 2022 the probabilities increase, but only slowly. Through Q1 2022, they remain largely the same as December 2021’s 4 percent. The furthest-out widely traded contract is for July 2022, and it only prices in Fed Funds at 0.125. That’s smack in the middle of the current 0 – 25 basis point band, but current effective Fed Funds are actually 8 basis points. By our math that pricing still implies a strong (+70 percent) probability that Fed Funds will not have moved by then.

Lastly, there is some chatter about what the FOMC might do with the 2022/2023 “dot plot” of participants’ expectations for future policy in the March 2021 Summary of Economic Projections which we will see this Wednesday. By way of review:

  • In June 2020, there were only 2 “dots” above 0 – 25 basis points for 2022 policy rates. (I.e., 2 FOMC members thought the US economy would be strong enough by 2022 to allow the Fed to raise rates.)
  • In September 2020, there was just 1 “dot” above 0 – 25 basis points. There was for the first time, however, a 2023 “dot plot” and there were 4 “dots” above 0 – 25 basis points.
  • In December 2020, the number of “dots” for 2022 above current policy rates remained at 1, but there were 5 “dots” above 0 – 25 basis points for 2023.

Takeaway (1): given all the recent strength in the US economy, vaccine rollouts and pent-up demand for travel/leisure activities the Fed will 1) likely increase its GDP and inflation forecasts but 2) do very little if anything to its rate forecast in the March 2021 SEP. That’s hardly controversial stuff, but there is a segment of the market (mostly in fixed income) that wants/needs to see the Fed actually verbalize these projections.

Takeaway (2): We think it is telling that the 10-year Treasury broke out to fresh 1-year high yields of 1.62 percent on Friday, just ahead of the Fed meeting this week. This is something like a stock making a new high ahead of an earnings release. Maybe someone knows something, or maybe it’s just the market jamming the mosaic together into a tighter picture. Either way, it’s an important signal and sits well with the idea the Fed will be upbeat on the US economy and very, very reassuring that Fed Funds are going nowhere any time soon.

Item #2: Two thoughts on 10-year yields

First: if we showed you this chart and said it was a stock you should buy, how long would it be before you said “Um… no thank you…” It is, of course, the yield on 10-year Treasuries going back to 1962. We’ve highlighted January 2010’s yield of 3.63 percent to give a sense of scale. Even at Friday’s close of 1.6 percent we’re still not even halfway back to those levels.

The long run trend to lower rates is unmistakable, and about the best level one might imagine 10-years going would be right around 3 percent. That’s where yields were at the end of 2018 (that small pop just before the yellow recession shading above). This was, of course, not a great period for stocks (Chair Powell quickly changed course in January 2019, removing the equity market’s rate concerns) which is one reason there is so much trepidation about 10-year yields climbing so quickly now.

But here’s the thing, as New Yorkers like to say when summarizing a thorny matter: if the Fed keeps rates low through 2022 then history says 3 percent 10-year Treasury yields is a reasonable base case.

Here’s why; this chart shows the difference between 3-month Treasury bill yields and 10-year Treasury note yields back to 1982.

We’ve highlighted the same January 2010 period as the above chart, and this shows that there was a 3.55-point difference between 3Ms and 10Ys back then. Now, scan your eye across the post-recession periods back to the early 1980s. In each case, without exception, 10-years always have at least a 3-point yield advantage over 3-month notes at some point in the recovery.

Takeaway: a 3.0 percent 10-year Treasury yield may be unthinkable given Federal Reserve bond buying just now, but it is fair to say that markets know that is where this paper should trade in a strong economic recovery. We’re not professional Fed-whisperers by any means but it seemed very much like Chair Powell could have talked rates down during his WSJ chat 2 weeks ago but didn’t rise to that bait. We’d be surprised if he changes his tune this week during his press conference. We’re sure he knows the 3M – 10Y chart too …

Sources:

Prior Fed SEPs: https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm