Last week, Kaplan suggested that his long term neutral FF rate was closer to 2.5% than 3%. I’m going to assume that his dot is going to be at 2.625% later this month. This got me to thinking about the relationship between the Fed’s mean long run Fed Funds rate projection from the SEP and the 30 year Treasury rate. The Fed actually sets the target Fed Funds Effective rate (“FFER”), and there is generally a tight relationship between the FFER and Treasury rates. I know people who think of longer run Treasury rates as a strip of Fed Funds rates (as an approximation), to compare value. So the two rates seemed natural to compare.
If someone on the Committee (who sets the rates) actually believed that 2.6% was the long run Fed Funds rate (based on the current environment, subject to change), it seems to me that they would think the 30 year Treasury rate should be lower than 2.6% in the current environment of zero term/risk premiums. This is because it will take some time (possibly years) to get up to the long term rate. The chart on the right of the two rates is interesting because it somewhat corroborates my theory that with “zero” term premiums (as is currently), the long run FF rate roughly caps the 30Y Treasury rate. We can see that during the taper tantrum, the 30 year Treasury rate surpassed the Fed’s long run projected rate – that would have been a good point to buy fixed income (or at least get out of shorts). We can also see that after the elections, the 30y rate surpassed the Fed’s long run rate for a time. That also would have been a good time to exit shorts or scale into longs.
It’s also interesting to note that the two times when the 30 year rallied too much (mid-2012 and early 2015), the 30 year yield was about 150 bps lower than the long run Fed Effective rate. I realize this is a whopping sample size of two, but I thought it was interesting. Any time you have a rough guide as to when the markets may stop going nuts could be useful. With last year’s Brexit vote, we only dipped about 100 bps, but I suppose as rates go lower, you can’t expect as a large a dip.
I also find it interesting that we had a large drop in the long run Fed Funds target after Brexit. And during the pop in inflation earlier this spring, we didn’t get much of a pop in the target rate. The fall in the long term FF projections seemed to have leveled off. But if Kaplan is dropping his dot from 3.0% to 2.625%, that is a substantial fall.
We need to keep in mind that Kaplan has recently been one of the more dovish members of the FOMC, and other “dovish” members (like Yellen and Dudley) don’t seem quite as dovish. I would expect the mean of the Fed’s longer run dots to come in slightly at the next SEP, but nothing Kaplanesque. Inflation hasn’t exactly been gangbusters, but payrolls have been firm and the core members still seem to be sticking to “the transitory dip in inflation” story.
The interesting question becomes, as the Fed starts normalizing their balance sheet, do we get some term premium to go back into the curve? If the answer is “no” and term premiums stay around zero, AND other members of the Fed think the longer run Fed Funds rates go lower (like Kaplan), then it may be that 30 year yield is too high. If the answer is “yes”, then we may see a breakout of the 30 year Treasury above the FF target “cap.” It will be really interesting to see what the market reaction will be to the Fed taper next month – both the initial reaction and the longer term reaction.
 I just took a simple arithmetic mean of all FOMC members submitting a dot. The SEP started in 2012, so the above is all the data available.