How Fed Skeptics May Cause the Tightening Cycle to Go Faster Than the Market Expects
If all the Federal Reserve's hopes and dreams for the American economy come true, the tightening cycle won't look anything like what futures markets are pricing in. That's the assertion of Steven Englander, global head of G10 foreign exchange strategy at Citigroup.
Market pricing of the central bank's glide path has been warped by a relatively small group of people who think that the Fed is never going to escape the zero lower bound, observes Englander.
These pessimists are depressing the expected pace of Fed tightening to the extent that it fails to provide much in the way of proper perspective as to where the federal funds rate will go if liftoff is successful. In the event that these negative outcomes do not come to pass and such views are expunged from market pricing, the expected pace of Fed hiking would shift higher, all else equal.
"Paradoxically, if a substantial minority thinks that the U.S. economy is weakening on its own, or will topple over because of lift-off, the implied pace of hiking if the economy does not weaken faster," he explains. "If, for example, 40 percent of the market thinks that the tightening cycle will quickly end, the 53 basis points [of hikes per year through 2017] now priced in reflects only 60 percent of the market. And presumably that 60 percent thinks rates will be going up faster."
The strategist believes that at least 35 percent of market pricing is dictated by the pessimists and concludes that the "pace of hikes could end up being almost twice as fast if the Fed's baseline view [for employment and inflation] is correct."
This development, he adds, would give the U.S. dollar a boost of at least 5 percent as investors recalibrate the glide path for rates higher.
In a sense, Englander's argument is the mirror image of HSBC Strategist Lawrence Dyer's chief quibble with the Federal Reserve's dot plot. Whereas futures markets do not adequately reflect what could happen to the Fed's policy rate if everything goes as planned, the Fed's dots don't allow for the possibility of the end of this expansion. Monetary policymakers' projected pace of tightening is contingent on the realization of their forecasts, which do not include a contraction in the U.S. economy.
Separately, Neil Dutta, head of U.S. economics at Renaissance Macro, writes that investors have a terrible recent track record when it comes to pricing in the magnitude of tightening or easing cycles once an inflection point is hit:
"Typically, in the front end of tightening cycles, the market is priced for a very shallow path of rate hikes, emphasizing 'one and done' and 'two and done' type scenarios," he writes. "[T]he market usually finds itself on the wrong side of the short-end rates trade, too dovish on the way up and too hawkish on the way down. History is likely to repeat itself."
So the three certainties in life, it seems, are death, taxes, and markets being wrong about the Fed at the start of a new regime, as Dutta reinforces.
Englander's thesis offers a compelling explanation for why this time will be the same.