If someone were to have told me last year that a significant majority of economists thought the Fed was going to hike at the next meeting and the highest year spread would be 76bps, I would have referred them to the local drug rehabilitation center. And yet here we are. The big issue I am trying to come to grips with is that it seems absurd to me that the Fed could hike when they are not confident they would need to hike well above 100+ basis points. If you had so much confidence inflation gets back to 2% (enough to hike), you should presumably be hiking the whole way there (i.e. more than a few times). Yes – things can change, but for the better or worse.
As a result, the fact that people have been piling into shorts in the reds is probably not a huge surprise… and they have been losing money fairly consistently for two months now. I can’t blame them – wouldn’t you think that if the Fed were going to hike by the end of the year, that the “baseline” scenario after liftoff would be they hike about once a quarter (100bp year spreads)? In the last hiking cycle, they hiked twice a quarter.
Part of the answer is that the economists and the markets disagree on the hiking percentage at the next meeting. The markets are currently pricing in a little less than a 35% chance of the Fed hiking in September. 35% is more commensurate with 3 hikes in a year. But 35% still seems too high.
As you all know, I like playing a game called “conditional probability.” Take a step back and look at the relationship from a different viewpoint – if you were given that Z5-Z6 spread was 76, what would you estimate the odds of a hike this year to be? On the right is a 6 month scatter plot of EDZ5 vs EDZ5-Z6 spread. If we are given that Z5-Z6 spread is 76bps, you would expect the amount of hikes priced in by year-end to be 7-8bps lower. The historicals corroborate what I would have thought about hiking probabilities this year.
I’m not saying the Fed couldn’t hike this year. But the markets are starting to price in that it may be “wrong” for them to do so. Earlier hikes could stall the fragile recovery, and thus the Fed may not have to hike as much – even as early as Z5-Z6. The current economist narrative seems to be “a journey of 1000 miles begins with one step, so start walking!” I would like to think I could place a little more faith in Yellen, and that she won’t start walking without planning out the entire trip. That is, if she can’t make significant progress, she will wait for a better opportunity.
 Two weeks ago, the WSJ showed that 82% of economists thought we get a September rate hike. I assume a majority of them still think this is the case.