Public Trust Advisors Blog

Don't Fight the Fed?

Posted on Fri, Jul 28, 2017

Four times a year, members of the Federal Reserve (the Fed) release their projections for economic growth, unemployment, inflation, and the underlying interest rate associated with these forecasts. This interest rate projection, known as the “dot plot,” serves as a guide of where the Fed expects to take interest rates over time. Whenever the Fed releases an updated set of projections, it has the potential to be a market-moving event. For this reason, the recent disparity between the Fed’s dot plot and what the bond market is actually pricing into the yield curve should be of particular interest to fixed-income investors.

The saying “don’t fight the Fed” implies that investors tend to fare better when their interests are aligned with that of the Federal Reserve rather than against it. However, the bond market continues to take a less positive view of the economy than the Fed. Unfortunately for those that set monetary policy, the market’s pessimistic view has proven to be a bit more accurate for some time now.

07.17 Dot Plot.png
To illustrate, in December of 2015 the Fed raised its target rate for the first time in seven years. From the Fed’s perspective, the rate increase was warranted by the steady improvement in the labor market and confidence that inflation would gradually rise towards its 2.0% target over time. Moreover, the accompanying dot plot projected four additional rate increases in 2016. However, the bond market wasn’t buying it.
 
Source: Bloomberg

As it turns out, financial conditions rapidly deteriorated in January of 2016. At the low point in February, the possibility of even one rate hike from the Fed seemed implausible. Ultimately, we did see one rate hike in late 2016. So much for that December 2015 forecast, but the truth is that a lot has changed since the early inception of the infamous “dots.”

When the Fed first released the dot plot in January 2012, expectations for rate hikes were priced far into the future. Now, every Fed meeting is assumed to be “live” where the decision to raise rates could occur at any time. The Fed’s message has been garbled at times, but it has stressed a desire to move away from time-based forecasts to analyzing the current economic conditions before acting. For example, the labor market has recovered to its pre-crisis level, and the Fed is keenly looking for signs of inflation before pressing on with further rate increases.

While probably wise to not “fight the Fed,” we must simply realize that these dots are not carved in stone. As before, the Fed is still a bit more optimistic, and we have seen two rate increases so far this year. According to the dot plot, one more hike is projected for this year, but the market based probability for another rate increase before year end is less than 50%. Just keep in mind that either position could be correct, as it all depends on the future performance of the economy and relative stability of the financial markets.

Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

Tags: Federal Reserve, The Fed, Rising rates, Public Trust Advisors, Investing Public Funds, Dot plot, LGIP Rates, Short-term interest rates

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