In case you haven’t noticed by now, Trump’s election and subsequent nod to fiscal stimulus in his acceptance speech have ignited the previously illusory “reflation” trade.
Suddenly, the Fed’s outlook for rates doesn’t look so unrealistic. Indeed, the vastly improved outlook for growth and inflation under Trump has the market betting on a much more hawkish Fed, even as the pessimists among us might be inclined to believe that the new president will be unable to pass stimulus measures through Congress in time to avert a recession, meaning that ultimately, fiscal stimulus will need to be funded with helicopter money and concurrent low (or even negative) rates.
On Monday, Deutsche’s Joseph LaVorgna is out with a look at 4Y1Y OIS rates on the way to showing that market expectations have rapidly converged on Fed forecasts – and that, if you’re the FOMC anyway – is a good thing…
The markets’ expectations of the longer-run funds rate have converged to the Fed’s forecasts. And when the Fed raises rates, it is unlikely to lower its median longer-run “dot”. This has hardly been the case, as the Fed has revised its forecast of the longer-run or “neutral” rate substantially downwards. For example, the median projection has fallen from 4.00% as recently as March 2014 to 2.88% as of this September. Figure 1 below illustrates this decline in the Fed’s longer-term rate expectations. It also shows the one-year overnight indexed swap rate four years forward (i.e., the 4Y1Y OIS rate). The OIS rate is a fixed rate that is swapped against the effective fed funds rate. Therefore, the 4Y1Y OIS rate is a proxy for long-run market expectations of policy rates, independent of business cycle developments. Note from the figure that markets have consistently been much more pessimistic than the Fed on the path of policy rates. Moreover, the gap between the Fed’s neutral rate expectations and those of the markets widened considerably from 92 bps in March 2014 to 179 bps in September 2016. In other words, the markets’ assessment of long-term policy rates fell much faster than that of the Fed, raising questions about the credibility of the Fed’s forecasts. Notably, the former was also relatively unresponsive to easing financial conditions earlier this year. Despite a 17% rally in equity prices from their intra-year low, reached on February 11, the 4Y1Y OIS rate was essentially unchanged on October 25 from its level on the former date (1.21%). However, the financial markets’ outlook on Fed policy has undergone a paradigm shift since the US Presidential Election. This is likely due to expectations of improved growth and inflation, and a much more hawkish Fed in the medium term. The 4Y1Y OIS rate stands at 2.16% at the time of writing, up a whopping 79 bps since Election Day (November 8). As a result, the gap between the markets and the Fed has declined to just 71 bps