Some Fed Math Into Wednesday's Meeting Says It's Hard To Be Dovish
An inside baseball look at the Dot Plot and the historical Fed reaction function suggests it will be hard for the Fed to have a dovish surprise this week.
As folks are obsessing about whether or not the Fed will cut 25 or 50bps this week, I think there is significant value in understanding how Fed members try to use the Summary of Economic Projections (SEP, Dot Plot) to help guide the market about what their actual cutting intentions are at any point in the economic cycle. As I have been suggesting, I think there is significant scope for disappointment here as the market seems to have really front run the Fed's reaction function this time...once again.
For the September 2023 SEP, the Fed assumed YE24 real yields of 250bps and YE25 real yields of 160bps (FFR less core PCE estimate).
At the December 2023 SEP, the Fed assumed YE24 real yields of 220bps and YE25 real yields of 140bps.
At the March 2024 SEP, the Fed assumed YE24 real yields of 200bps and YE25 real yields of 170bps.
At the June 2024 SEP, the Fed Assume YE24 real yields of 230bps and YE25 real yields of 170bps.
The average of the last 4 Dot plots showed the Fed expected real yields (FFR less Core PCE) at YE24 at +225bps and YE25 at 162.5bps.
Currently the market is assuming that YE24 real yields will be 150bps (4.20% FFR less 2.7% core PCE) and YE25 real yields of 60bps (2.80% FFR less 2.2% core PCE). So markets are saying the Fed will be comfortable with real yields at YE25 of only 60bps, nearly 100bps below where the Fed has been for the last year. This estimate of +60bps of real interest rates is even below the 100bps average real yield the Fed has been saying they expected YE26 to be. So the market is significantly ahead for next year where the Fed expected to be at the end of 2026.
What would be the justification that the Fed would/could use to say that real yields should be about 100bps lower to end YE25 that what they have expected on average for the last 12 months? Has the economy really evolved in a way over the last 3 months that would justify such a rapid reduction in real interest rates?
It just seems like acknowledging something as aggressively dovish as the market is expecting would suggest that the Fed is just being led by the market, rather than leading the market to where rates should be which should be their job (Fed instructs the market, not market instructs the Fed according to Volcker).
It appears like the Fed has a significant communication problem where the market doesn't really understand their reaction function in an environment where inflation continues to run above target but the Fed hasn't really done much lately to change how the market behaves either. This is a Fed that has consistently forgot about how loose they have allowed financial conditions to remain through most of this cutting cycle, which has made their job more difficult as well.
I believe the Fed "should" use the Dot plot to once again remind the market they are in charge. However, we have to trade what they will do, not what they should do. If Powell is hard pressed to start with a 50bps cut, deal with hawkish dissents for the first time since Covid, explain to the press why a rapid cutting cycle to neutral is coming and necessary, he will do it but I believe doing so would really threaten the Fed's credibility and how they use forward guidance in the future. If he did so, I would expect the $ to get rinsed, gold and equities to rally.
My logic framework tells him Powell starts with 25, the dots come in more hawkish than expected but Powell tries to use the press conference to remind folks that he can always do more later. Given the gap between where the market is currently and where the Fed is likely to come out at this meeting, I think there is scope for disappointment for risk assets and I would be moving more aggressively negative on equities if this is the outcome that comes through, particularly as we head into the historically weakest time of the year for stocks in the second half of September after expiry.
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