TheChek News Flow

Now that the major downside risks from Greece, China and Iran seem to be under control, investors are redirecting their attention to a much more familiar question: will the Fed impart a nasty shock to US monetary policy before the end of the year? The markets have largely ignored the Fed’s machinations since the taper tantrum in the summer of 2013, but they can do so no longer.

Janet Yellen’s testimony to Congress last week clearly signaled that the FOMC is almost ready to announce lift-off in US rates. The ides of September (or, strictly, three days later, at the FOMC meeting on 16 September) now seems likely to be the fateful date that markets have dreaded for years.

Although economic forecasters are expecting a September lift off, this starting date is still not fully priced into Fed funds futures (see Tim Duy.) What really matters, however, is whether the Fed then embarks on a medium term tightening path that persistently surprises the markets in a hawkish direction.

That is what has happened in each of the three previous tightening cycles, which were periods when fixed income traders consistently lost money by taking long positions at the front end of the yield curve. The current market pricing for forward short rates, which remains far below the Fed’s “dots” for the next three years, suggests that there is a strong possibility that this accident could repeat itself in the coming tightening cycle.

For about three decades, it has generally paid for traders to assume that the Fed will deliver a path for short rates that is lower than that built into the forward curve for interest rates at any given time. Maybe that partly reflects the fact that a risk premium is normally priced into forward interest rate curves. But, in addition, interest rates have been on a long run downtrend, with the Fed repeatedly choosing to deliver easier monetary policy than the market has expected. “Never underestimate the dovishness of the Fed” has usually been a profitable motto for traders.

There have only been a few brief exceptions to this rule. As the graph on the right shows, the forward money market curves for short rates (the grey lines) have generally been well above the path for short rates that has actually transpired (blue line), so traders holding long positions in short rate contracts to maturity have made profits.

The exceptions to this rule, however, have come when the Fed has embarked on a path to raise rates, in 1988-90, 1994, 1999-2000, and 2004-07. In those periods, the market did not believe that the Fed was really serious about tightening monetary policy, and lost money by betting on a dovish central bank.

The question now is whether we are entering another of those exceptional periods during which the Fed surprises the markets by tightening more than expected. This depends on two factors: the date of lift off, and the speed of rate increases thereafter.

The date of lift off is still a matter of contention. Recently, the IMFhas argued that it should be delayed until next year, and Paul Krugman has said that the costs of wrongly acting too soon are much smaller than the costs of making the opposite mistake.

For a long while, Janet Yellen seemed sympathetic to this asymmetry of risks, but lately she seems to have shifted her stance. Her recent message has been clearly tilted towards a path for rate increases that is “early and gradual” rather than one that is “later and steep”.

Last week, she went as far as to say that “the economy cannot only tolerate but needs higher rates”. That is an unusually hawkish choice of words for a Fed Chairman who is usually viewed as a dove.

Ms Yellen has been supported in this shift by her main lieutenants, including Stanley Fischer, William Dudley and John Williams. Paul Krugman says that the reasons for this shift are “mysterious”, and certainly they were not fully spelled out in last week’s Congressional testimony, which focused on the usual debates about the labour market and inflation.

But Ms Yellen outlined her underlying case much better in her important speech on the “normalisation” of interest rates on 27 March. She believes that rates are now well below “normal” while the economy is virtually at normal. Here, “normal” for rates is defined as the equilibrium real rate, which Ms Yellen expects to rise as economic “headwinds” diminish in the next few years.

As this blog has argued before, analysis of the Fed’s forecasts shows that it is this rise in the equilibrium real rate, rather than the projections for inflation and unemployment (which are both assumed to be “on target” by next year) that drives the upward path for rates in the medium term.

Ms Yellen continues to argue that the upward path will be “gradual”. In an illuminating interview with the FT on 28 June, William Dudley explained that he interprets this to mean that rates will rise by 25 basis points four times a year, or at alternate FOMC meetings. That would be about half the pace seen in the 2004-07 tightening cycle, but it would still be much faster than the pace currently built into the market forward rates.

Wiiliam Dudley also emphasised that the comment about gradualism should not be regarded as a “pledge”. It is just a central expectation, based on the Fed’s current forecasts for inflation and unemployment. If the economic outcome differs from the forecasts, then so too will the the paths for equilibrium and actual interest rates. That is what the Fed means when it says its actions will be “data determined”.

That uncertainty gives the markets just about enough reason to adopt a much lower path for forward short rates than shown in the Fed’s current view of the future. But, at this stage of the cycle, the markets have often been wrong about the Fed’s readiness to tighten policy, and they may well be making the same mistake again.