By now everyone realizes that the Fed didn't announce the anticipated reduction to their bond purchases (i.e., "taper") at the end of their two day meeting on Wednesday, September 18th. But the question of why not is still nagging investors even though the knee-jerk reaction was to rally bonds (lower yields) and rally stocks. But since, the market is a bit schizoid running amok with thoughts of "oh my gosh, they know the economy is bad" putting a hamper on equity prices at least. However, we believe the explanation is simpler. Expectations, according to the bond market, had gotten ahead of the Fed's own expectation and they didn't want to reinforce that view and its potential impact on the economy. I know, it sounds complicated but it's not, trust me.
Below is a chart of the December 2015 Eurodollar contract from the CME. It measures what the market thinks the 3-month LIBOR interest rate (a proxy for the Fed Funds o/n rate or IOER) at the end of 2015. It's inverted to pretend it's a price instead of a yield but it really is a yield. One takes the "price" subtracted from 100 to get the yield. You can see the increase in rates (price down) in August when the taper chatter began and the price bottomed out at about 98.1, which says the market expected the Fed Funds rate to be a bit below 1.9% (there is a small spread between the two rates). Needless to say we've rallied some since then and one can see the big jump, about 20 bp, when the Fed announced no tapering. The same could be witness in bond ETFs like TLT, for example.
December 2015 CME Eurodollar Contract
Below we show a chart and data of the so-called Eurodollar curve, for different contracts (i.e., forward time), along with the Fed's median estimate from the last meeting. The Eurodollar curve, or market expectations, are from yesterday and from their peak earlier this month. The Fed's estimate, labeled 'FED', is from 17 participants of where they see the short-term interest rate at those same time intervals presumably based on their economic forecasts and their stated policy (e.g., begin raising rates when unemployment is definitely below 6.5%). We can see the aggressive rate rise that was priced into the market in early September and we suspect the Fed was looking at the same thing. Since the Fed announcement, the market's expectation is more aligned with the Fed's, albeit still higher, primarily in the nearer-term; long run expectations, which we use 2020 as the time stamp, the market is still quite a bit higher. To put some numbers on it, earlier this month the market expected the funds rate to be about 1.9% or so in late 2015 (the contract shown above). However, the median Fed prediction was between .75 and 1%, a decidedly different view.
Eurodollar Interest Rates and the Fed's Expectation
With market expectations having run amok relative to where the Fed thought they should be (not even risk premium or LIBOR-FF spread could explain the difference), it probably gave the Fed concern since it was based on the view that they would begin mildly tapering and lower bond purchases by $5-15bn/month. There are two reasons for that. One, they did not want to reinforce the market's message by starting to taper while rate expectations were too high. Second, they were probably concerned about what the effect of these higher rates would have, if they came to fruition, on their own forecasts. In other words, if the market was right and that was the true path of short-term interest rates, then likely the Fed would not meet its economic mandate anytime soon. It's a catch-22 or a feedback system. And, just as in control systems, it's the path, or total signal response, that needs considering when applying an impulse (think steering a huge tanker).
So, our view is the Fed implicitly understands the feedback effect that the "too high" interest rate expectations would have on the trajectory of the economy and they wanted to insure they were both aligned. We don't think it was a reflection of a souring economy. It was more like, well if you want us to taper now, don't over price the liquidity removal in the future. We also think the Fed was a tad concerned with what was occurring in the mortgage finance arena and the nascent housing recovery. In particular, many mortgage investors were taking book value hits and, while the Fed is not in the business of protecting investors, they do not want to see the mortgage credit pipes clogged. What this means to us is that rates will probably need to show stability at the 2.5-2.75% range (10-year Treasuries) and fresh economic data over the next month or two needs to show resiliency in the face of these higher rates - then they will taper. If the market tries to get ahead of the Fed, they will trump it again by prolonging the tapering process. It's a game of chicken. For investors it means that interest rate sensitive sectors, like mREITs for example, will be in for a respite as we look for rates to stabilize and volatility to decline. We also think that using the non-tapering as a thesis to put on risk-off trades (e.g., buy gold - GLD) would be a mistake.