Conflicted Fed creates opportunity

December 24, 2014 04:16 AM

The Fed removed the phrase “considerable time” in December’s FOMC statement seemingly clearing the path for rate tightening and setting a path toward a more normal policy stance. Janet Yellen also made it clear in her press conference that followed that the initial lift off of zero would not take place in either of next two meetings (Jan. 27-28 and Mar. 17-18) but left the door open past there. The Fed has also stated that their decision to tighten is “data dependent” which seems simple until you listen to individual committee members give their opinion of the data.

There were three dissents among the voters in this past meeting which in itself is a bit unusual but the fact that two came from the “Hawkish” side and one from the “Dovish” side shows the wide range of opinions on the economy. Minneapolis Fed President Narayana Kocherlakota, maybe the most “Dovish” member, was on the wires stating his case Friday as was Bank of San Francisco President John Williams, who is slightly “Dovish” and what stuck out to me was how far apart their opinions are. The Fed’s objective of full employment looks to be head in a good direction but its 2% objective for inflation is proving difficult. Markets are showing the wide differences of opinions with increased volatility but increased volatility means more opportunity.

With expectations of a Fed tightening within the next year, Fed Fund Futures have seen more movement and an increase in volume and open interest (see chart below). Fed Funds pricing is based on 100 minus the average daily Fed Funds overnight rate of the contract month. For example, 2.00% would be 9800.

The above chart shows market movement of the Fed Funds June 15, Sep. 15, Dec. 15 and Mar. 16 that show what the market is expecting to price in over the next year.  The Sep. 2015 is pricing a full .25% tightening with a small chance of more. The Dec. 2015 contract has a bit more than .50% of tightening priced in. Comparing that to the Fed forecast (the dots) which has a median expectation of 1.27% by the end of 2015 means that there is opportunity!

 Outlooks and opinions included are those of the author and not necessarily RCM


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