On Thursday the Fed will announce whether or not they will raise the FF target and begin the process of “normalization”. At the quarterly FOMC meetings, there is both a press conference, and the Fed releases the SEP, or Summary of Economic Projections, which includes the dot plot where the members of the committee give their estimates of what the FF target should be at year end over the next few years.
As I have mentioned previously, growth and inflation projections by the Fed are typically well off the mark. Additionally, the dots have been wildly different from what the Eurodollar futures curve is pricing (with the dots indicating much higher rates). For the purpose of this note, we will simply consider the projections for yearend 2016, now only 1 ¼ year away. In March, the Fed dots (17 members, simple average) projected a FF rate of 2.02%. The day before the announcement, EDZ16 settled 98.335, a rate of 1.665%. Keep in mind that there is a spread between FF and euro$, so an implied ED yield of 1.665 is consistent with a FF target of under 1.5%. In any case, the difference between the FF projection and the ED market was 35.5 bps (2.02 – 1.665).
In June, the average dot projection was 1.75% vs EDZ6 price (the day before) of 9851.5. That yield, of 1.485%, is consistent with a FF target of around 1.25%. So the Fed dots came down about ¼%, while the ED contract came down 18 bps. Given that one-year Eurodollar spreads have been 60 to 70 bps, there is a natural roll up the curve of about 15 to 18 bps per quarter, so the EDZ16 contract, even though there was volatility over the quarter, ended up essentially simply rolling up the curve, and the Fed moved somewhat closer to the market.
Tuesday EDZ6 settled 9883.0, 31.5 bps higher than it was in June, so the contract rally has outpaced the natural roll. Makes sense of course, as economic data has been mixed over the time period and the large decline in oil prices, which negatively impacts inflation expectations, began in June. The point is that both the dots, and likely the economic projections by the Fed almost necessarily must be trimmed. To keep pace with the market, the 2016 dot average would have to decline by around 30 bps to 1.45%. Of course, that would still entail about five ¼% hikes by the Fed prior to the end of 2016, which doesn’t seem particularly likely unless the Fed gets started Thursday, given the constant repetition that rate increases are likely to be gradual.
The point is, if the Fed DOES hike on Thursday, the subsequent press conference and the SEP are likely to lean quite dovishly, confirming the idea of very gradual tightening. If the Fed refrains from moving, I think Yellen will still talk up the idea of an impending return to normalization through near term rate hikes. But a lower dot plot might limit the effectiveness of such statements.
