One of my former colleagues at JPM was a rocket scientist – literally.  We once discussed how for some corrective system models, you can have a situation where you overshoot before eventually settling to the equilibrium.  That conversation was what I thought about when I saw the Fed’s dots last week.

The way the Fed models tend to work is that there is a bit of an overshoot on rates, because Fed policy generally takes a number of months to take effect.  So if the Fed had the foresight of a bat, they would keep hiking as they saw inflation and growth pressures, and stop hiking when they no longer see inflation and growth pressures.  They may then have to reverse course and lower rates if an overcorrection was made.

Let’s take a look at what the Fed dots are trying to communicate.  As you know, I think the median is the dumbest way of assessing where the FOMC is, in a system where not everyone’s opinion counts the same.  Sure, they’ll say everyone’s vote counts the same.  That’s what you tell your kids when you are voting on whether to go to Chuck E Cheese or McDonald’s.  On the more important decisions, you just steer the kids to where you want to go.  What we really care about is where the governors and the Chair are.  To account for this, in the past I took out the high 6 dots and the low 2 dots.  I had been thinking about removing only the high 4 dots, but for the sake of continuity, I will keep it at removing 6 and 2, until we know the full composition of the Board of Governors.

The table on the right summarizes the mean of the Fed dots with the high 6 dots and low 2 dots removed.  There are a number of interesting things to take away from the table:

  • You should note that we are not comparing apples to apples between December and March, because Yellen’s dot is no longer there. Since she was one of the more dovish members, this would have the effect of nudging up the dots.
  • You can see why someone would want to buy 2019 and 2020 hikes (EDZ8-Z9 and EDZ9-Z0 respectively). We have seen massive volume in those year spread go through the few days before the FOMC meeting.  However, on a one-year-basis, the largest increase in hikes occurs in 2018!  (highlighted in yellow)  That on the margin should have made the butterflies centered around the back whites increase the most, if it was not for the libor issues (for ED flies) or the trade tariff squabbles.
  • What is most curious is how the long run rate is LOWER than the YE 2019 rate. This is highlighted in orange.  Where this stands out the most is in comparing the 2020 and the long run dots.  The rate overshoot in 2020 increased noticeably since the December meeting (highlighted in red), to an astounding 46bps.  This has many names – “overshooting because of lags in policy,” “policy error,” “Fed inducing a recession,” “Central Banks stupidity,” etc.

I think this Fed will be a little different than what the Fed models (dots) predict.  Why?  A combination of: (1) the Fed being gradual and accommodative, (2) the Fed also tapering reinvestments, (3) larger Treasury issuance, (4) structural inflation changes, (5) lower inflation being global, and (6) the Fed reluctance to invert the curve.  I discuss these factors in the Trade Thoughts section.