by Neil Azous, Chief Investment Officer
- A Model Driven Approach To The Federal Reserve
- Probability Framework
- Unconditional Probabilities
- Four Quadrants
- The Qualitative Arguments
- Conclusion
A Model-Driven Approach To The Federal Reserve
When evaluating the outlook for interest rates, it is essential to know what the market expects to happen in the future relative to our expectations. A prediction, or forecast, of the 10-year US Treasury yield, at any future point, is meaningless unless we know what that expectation is relative to the market’s and how realistic it is that the path may evolve between now and then.
Using our Federal Reserve model, we can “digitally” recreate hundreds of scenarios that are priced into the US interest rate market. The ability to recreate and play the expectations embedded in the US Treasury yield curve provides us the ability, with precision, to determine what is the greater risk: higher or lower interest rates. This is a very powerful and useful tool for asset allocation.
We have a high degree of confidence in our model-driven approach to navigating the contours of Federal Reserve policy.
Probability Framework
Our starting point is our probability framework.
Applying our probability framework to before and after last week’s Federal Reserve meeting highlights that the market has shifted from the “chances about even” to “probable” regarding the certainty of a hiking cycle occurring in the second half of 2022. Said differently, the market’s confidence in a hiking cycle has increased by 10-20% in probability terms.
Unconditional Probabilities
The bar chart below shows the unconditional probability of an interest hike at each quarterly Fed meeting between September 2022 and December 2023. The unconditional probability detailed below is the probability of an interest rate hike occurring at any specific meeting.
Today, the fixed income market is discounting a Federal Reserve interest rate hiking cycle starting in the second half of 2022. Our model highlights that the bond market is pricing the following probabilistic outcomes:
- A 60% probability that the Fed will begin its hiking cycle by September 2022.
- A 60% probability the Fed reaches the neutral rate from the last cycle (i.e., 1.75%) by December 2023. Put another way, the Fed will hike interest rates at the six quarterly meetings from September 2022 to December 2023 from 0.25% to 1.75%.
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- Sidebar: There is a less than 50% probability that the Fed “overshoots” and hikes beyond the neutral rate. This line in the sand is critical to monitor for managing risk assets. In 2018, the rolling bear markets across asset classes or pop-up thunderstorms were not related to the Fed hiking at consecutive meetings or normalizing interest rates. The destruction was caused by the Fed making a policy mistake by attempting to hike interest rates 50-75 basis points above the neutral rate.
- There is a 26% probability of the Fed hikes interest rates at the July 2022 meeting, one meeting after asset purchases are projected to end.
On the hawkish side, all probabilities can rise by another 10% to 70%. In that case, yields could rise another ~15 basis points. Note: While the bond market can always overshoot, it typically does not price the general area of possibility higher than 70% with at least a year until the first interest rate hike. Said differently, this is the bond market’s resistance level.
Four Quadrants
We group interest rates into four quadrants:
- Negative Interest Rates: Rates are below the zero-bound and the Fed has implemented Quantitative Easing (i.e., “QE”).
- Lower for Longer: An extended delay in raising interest rates, or “one hike and done.”
- Gradual Pace: A more gradual pace of interest rate hikes, or about two per year. This equates to the market pricing the equal probability of an interest rate increase, decrease, or no move at each meeting over the next 18 months.
- Measured Pace: A determined pace of interest rate increases, or about three or more interest rate increases over a 12-month period.
We believe the bond market is currently in the “Gradual Pace” quadrant, the second most hawkish of the four. It will not take a lot more to shift to a “Measured Pace.” Should interest rates rise another 15-20 basis points or 10% in probability terms in the short-term, a shift to the most hawkish quadrant of Fed policy i.e., a Measured Pace, is most probable to materialize.
The current ambiguity is related to time. The distance between now and the beginning of the hiking cycle is one year. In practicality, the degree of certainty is not high enough regarding when the cycle will start, or if it starts at all, to warrant a “Measured Pace.”
The Qualitative Arguments
There is one overriding subjective opinion we have regarding the path of Fed policy and how it pertains to interest rates over the next year. The bond market is priced for the Fed to begin raising interest rates within three months of its asset purchase program ending in September 2022. There is even a 26% chance they start in July, one month after, based on the Probability Framework. We believe this is too tight of a window for multiple reasons, depicted below in order of importance.
- As a yardstick, the Fed took 14 months after the only other tapering episode in 2013-2014 to raise interest rates once. Also, a full tightening cycle did not begin for two years. After tapering got underway back then, the 5-year US Treasury yield stayed in a 30-basis point range for almost three years. If you were long an intermediate-duration bond of any kind, you were rewarded handsomely.
- It is our experience that after the first significant shift in probabilities, which is occurring now, the market typically shifts meaningfully every 6-8 weeks (i.e., 10%-30% in probability terms up or down). This is especially true when the forward yield curve is steep, such as now, meaning the uncertainty level remains high.
- From the Fed’s perspective, there are too many unknowns resulting from the pandemic. As a result, the Fed has conveyed that the bar to raise interest rates is significantly higher than the hurdle to tapering asset purchases.
- Historical precedent suggests that the Fed is reluctant to make significant policy changes that could have an impact on national elections. In this case, US midterm elections in November 2022. This may be amplified by the potential for the House or Senate to flip parties because very few seats separate the majority in both bodies of Congress currently.
- The make-up of the Federal Open Market Committee (FOMC), specifically the inner core, is unknown. Chair Powell, two vice-chairs, and an open governor seat terms are all up within the next six months.
Based on these qualitative arguments, we are uneasy about how rapidly the bond market leaped from identifying the end of asset purchases (i.e., June 2022) to a “Gradual Pace” of interest rate hikes.
Conclusion
We believe the bond market is tilted too hawkish – our model reflects that. Even at a 60% probability that the Fed will begin its hiking cycle by September 2022 there is still too much margin for error. This is especially true regarding making significant portfolio construction shifts.
After the initial adjustment in yield concludes, nominal interest rates can remain range-bound for an extended period as the start of the hiking cycle gets pushed out beyond September 2022. However, the probability above 50% can remain embedded in the yield curve if the global recovery remains intact and the pandemic dissipates.
Along the way, especially in the short-term, the probability of the Fed hiking interest rates could rise to 75% or decline to 50% for a variety of reasons. These could be, but are not limited to, disappointment at the upcoming monthly employment report, China’s recent issues spreading contagion, the passage/failure of federal stimulus, or a significant decline in equity prices.
With this balanced mindset, we are going to do what is responsible regarding any asset allocation change. That is, any update will be made in the context that a structural shift is underway that could take many months or years to play out as opposed to the impact being felt imminently.
The good news, for now, is that we can see all this in real-time using our model and have mapped out the portfolio construction preparations should a regime change occur.
As a boutique firm, we can help you navigate these potential critical changes in the market by providing direct access to our investment professionals and library of tools. At Rareview Capital, our goal is to become a trusted resource and the first call for your questions. Please call us at 212-475-8664 or email us at info@rareviewcapital.com.
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