Leveling the Playing Field

September 14, 2015

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The FOMC is not hiking rates Thursday. Lets just go ahead and get that out of the way. I just
wanted to save you some time if you were in a rush this morning.
Fed Decision Dovish Hike or Hawkish Unchanged?
There is a 30% probability of a hike priced into Eurodollar futures and if the Fed actually
planned on hiking, Yellen would have sent her minions out to en masse to warn markets. The
FOMC has zero interest in shocking a jittery market and if it planned on hiking, we would have
received more Fed-speak by now. Yellen doesnt want to see graphs like this go haywire
heading into year end.

Over the course of this year, futures market have priced 20%-100% hike odds by September. At
30%, the Fed would have jumped in by now to adjust expectations if it planned on hiking
Thursday.
The odds for a hike by year end have fluctuated between 50%-100% and currently sit about 75%.
I bet behind closed doors Yellen is happy with this number.

Economists have also backed off forecasts for a September hike. Since economists are generally
the last to know, it feels like a neutral Fed is baked by now.

If the Fed hikes on Thursday, it would be doing so against market expectations, economist
forecasts, in the midst of some global turmoil, and an ongoing saga in China. This would
basically force Yellen to couple the decision with an overly dovish statement.
Those of you that read last weeks newsletter may jump in here and ask, Wasnt the title of the
newsletter Can a Rate Hike Be Dovish? Isnt this the exact scenario you described?
Yesandthere is no doubt the Fed will be very dovish when it makes the first move. But it
doesnt want to be too dovish. I probably sound like I am splitting hairs, but Yellen also wants
every meeting to be treated as a live meeting, giving her the flexibility to adapt to changing
conditions.
Hiking on Thursday could force her to couple the decision with an overly dovish statement to
offset out of fear of the resulting volatility and tightening financial conditions. Why not give
yourself another eight weeks, another month of job data, time for China to settle down, etc? Will
hiking eight weeks too late really be worse than hiking too soon?
Yellen is a dove at heart, and when in doubt, will err on the side of caution.
Therefore, we expect a hawkish unchanged rate announcement.

Roll Out the Red Carpet for the Blue Dots!

At every other meeting the FOMC releases its Summary of Economic Projects, or SEP for short.
You probably know them as the Blue Dots and this weeks meeting is one of the meetings with
these forecasts. Here is the Fed Funds Blue Dot forecast from the June FOMC meeting.

We believe this forecast (particularly the first twelve months) is more important at this point than
the actual FOMC rate decision. Even my grandmother knows a rate hike is coming and does she
really care whether it comes this week or the end of the year? Is anyones business actually
impacted by a 25bps increase? If it is, you should probably consider selling.
Remember, this is each FOMC member forecasting where he/she expects FF to be over the next
three years. While we have zero confidence in their ability to predict rates three years from now,
the near term is more accurate. We expect the 2015 column to reveal one rate hike, down from
the two hikes in the June forecast. And the 2016 column will likely shift down by one hike as
well, but only because of the reduction in the 2015 forecast. We think the FOMC will still
forecast four hikes in 2016 (even though it will probably be less), with a year end FF of 1.50%.
The Blue Dots also reveal the Feds forecasts for multiple economic data points. Following the
Q1 revisions from last month, these forecasts will likely be about 2.5% in 2016. This may be
offset some by the recent developments in China and the continued strength of the dollar, but it
seems clear the Fed will up its GDP forecast.

In June, the FOMC forecasted core PCE prices to finish this year at 1.3%-1.4%. While they are
now at 1.2%, this will likely not be revised given soft readings. The 2016 forecast may need a
minor adjustment lower from June's 1.6%-1.9%, but probably not enough to warrant a shift in
mentality.
On the labor front, the Unemployment Rate is already down to 5.1%, which will force the
FOMC to update its Q4 forecast from June where UR was at 5.2%-5.3%. With the Fed believing
full employment means an UR of 5.0%-5.2%, this forecast shift is significant. The Fed will
likely have to forecast an UR with a 4-handle in early 2016.
Say what you want about the quality of the jobs, but it is tough to argue that the Fed should
remain on hold because of labor markets.
October Rate Hike
Perhaps the second biggest argument against an October rate hike (after lack of inflation) is that
it is one of the off meetings, with no SEP release or a scheduled press conference by Yellen.
How could Yellen hike and not make herself available for a Q&A session?!?!
But on several occasions this year, most recently July, Yellen has cautioned that a hike could
come at any meeting. If the FOMC hikes this week, the market could interpret that as a sign that
the Fed will hike at every other meeting (just the ones with the SEP and press conference),
particularly if the Blue Dots suggest four hikes in 2016thats one hike every other meeting.
But the FOMC has no plans for a traditional tightening cycle this time around and doesnt want
the market getting complacent about non-SEP meetings.
Furthermore, its not like Yellen needs to give everyone a ton of lead time about a press
conference in order to ensure it is well attended. When I schedule meetings, its usually a month
out. People dont rearrange their schedules to accommodate a visit from yours truly at the last
second. But if Yellen says, Hey guys, Im gonna talk for a few after this rate decision, I
suspect people can figure out a way to watch and listen. So, lets remove that objection.
The bigger issue is the lack of inflation. Wage inflation has been absent all year until the
surprise reading two weeks ago. China will likely serve as a drag for the foreseeable future, as
will the strong dollar. PCE prices saw a year over year drop to 1.2%.
Remember, though, that the Fed doesnt need to see Core CPI at 2.0% in order to hike, just to be
"reasonably confident that inflation will move back to the 2% objective over the medium term."
Yellen et al have downplayed the inflation risks attributable to China, but this may be just to
prevent a backslide of expectations for a hike.
Many FOMC members have been suggesting that the case for a September hike was strong until
the recent market volatility. Assuming markets continue to settle AND data like jobs/inflation
arent surprisingly soft, October is looking like the right time for the first hike.

Rate Outlook
Everything is Fed-driven this week. Not surprisingly, yields have pushed towards the current
range highs as markets expect an accommodative Fed for another eight weeks RISK ON!
2Ts keep bumping up against 0.75%, but cant break through without a hawkish Fed statement
or aggressive Blue Dots that show more hikes in 2016 than currently forecasted. This feels
unlikely. This will help keep cap prices reasonable, although they will likely jump heading into
the meeting as vol spikes.
The belly of the curve is likely to experience the most volatility with a surprise Fed statement, as
rate expectations flow through this part of the curve. The 5T has spent the last few weeks
consolidating on 1.50%, awaiting direction from the Fed.
T10s spent last week grinding higher, moving up about 5bps on the week. The current technical
range is about 2.00% - 2.25%. If we test the upper end of the range, we should encounter
significant resistance. Traders are very cautious in this market given all the global headlines and
high yields mean cheap prices, helping to limit a dramatic push higher.
In all likelihood, this weeks FOMC meeting will be a non-event and all eyes will shift to
October. This probably means yields are range-bound for the foreseeable future absent a
surprise statement or global headline.

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