Past Prescient Futures: Markets Anticipate Timing But Not Magnitude Of Fed Rate Moves

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by: L. Myron Clark
Summary

Futures markets tended to anticipate actual Federal Reserve rate policy changes by about six months.

Changes in the Fed policy rate sometimes went much farther than the market predicted value.

Rapid and deep rate cuts may indicate a sudden course correction when events overtook the Fed's models and inputs.

The recent broadening and deepening yield curve inversion – when longer-term Treasury note yields fall below short-term ones - has stimulated a spate of research and commentary. One thought-provoking finding comes out of Scandinavia. Anders Svendsen, Chief Analyst at Nordea Group, found that futures markets tended to anticipate actual Federal Reserve rate policy changes by about six months.

This is consistent with other research: looking at past policy easing cycles, Arbor Data Science showed that Fed funds or Eurodollar futures correctly priced in upcoming rate cuts. The time lag varied widely, though, from about one to nine months between the market-implied cut and the first actual move of the easing cycle.

Svendsen’s research also shows that market expectations did not overshoot the bigger policy moves of the past. Six-month changes in the Fed policy rate held close to the market predicted value most of the time, but occasionally went much farther, especially to the downside. Life imitates the predictive art – but can also far surpass it.

This result seems, in some ways, contrary to economist Robert Schiller’s foundational research on equity volatility. He found that stock prices fluctuate much more than the dividends companies pay, which would be the rational basis of valuations. This put a big dent in the efficient markets hypothesis and led to Schiller’s 2013 Nobel prize (shared, congenially, with a leading efficient markets exponent).

Schiller’s observation is not limited to stocks: prices of bonds and other asset classes can also fluctuate more than their fundamentals would indicate. The field of behavioral finance has found varied explanations for this emotional (read: human) behavior. So why would it not also apply to traders in interest rate futures?

A different way to read the data is that the Fed got behind the curve at certain points in past business cycles, then had to play catch-up to either an inflation scare or a sudden slowdown in the economy. Critics of monetary policy like to say “The last rate hike is always a mistake.” This view is not valid when inflation is moderate and tightening cycles have ended well before the onset of a recession. Equity markets often continue upward for months or years after the last rate hike of the cycle.

U.S. stocks have been holding up well in the face of the latest yield curve inversion; the pressure on the Fed has come more from fixed income (reflecting falling inflation expectations) along with real-world indicators like shrinking global trade and softening labor conditions. But stocks can also be volatile to the downside, resembling the biggest rate declines in Svendsen’s chart.

Large stock drawdowns can persist despite aggressive monetary policy easing. An explanation consistent with both is the inherent instability of financial markets. Rapid and deep rate cuts may not indicate that the Fed made a policy error, but rather a sudden course correction when events overtook its deliberative models and inputs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.