All Eyes on the Fed

The Federal Reserve released the statement from its June meeting last Wednesday, which was followed by the standard quarterly post-meeting press conference with Fed Chair Yellen. Although officials chose to leave the policy rate unchanged, and only incrementally upgraded their assessment of the economy, Treasuries experienced a sharp rally across the curve on the statement’s release. Of particular note in the statement were the updates to the increasingly scrutinized dot plot. The dot plot represents each Federal Reserve member’s estimates of the path the Fed’s policy rate will take over the next 2 1/2 years. The dot plot was initially dismissed by Yellen in her March 2014 post-meeting press conference as less important than the Fed’s forward guidance, but since much of the time-specific guidance language has been dropped from the statement, the dots have become more relevant. Additionally, they are now considered a more flexible and potentially more effective policy communication tool, and therefore may continue to gain importance in the market’s eye. The Fed has been consistently overly-optimistic on growth, inflation and the future path of rates since the crisis. For example, the expected policy rate for the end of 2017 now sits at 2.875%, down from 3.125% in March and 3.625% last December. While the median forecast for the end of 2015 remained at 0.625% (implying 2 hikes before year-end), the number of forecasts for 0.375% (implying only 1 hike before year end) increased from 1 to 5. According to speculation from Goldman Sachs, this includes a shift from Yellen herself out of the 2 hike and into the 1 hike camp. The chart below highlights the slow convergence of Fed forecast (coming down) toward market expectations as measured by the forward rates curve. We continue to believe that the pace and terminal level of the policy rate are more important determinants of U.S. fixed income total returns than a September versus December initial hike time schedule, and in that regard continue to expect a slow and measured shift in the policy rate that will result in a gradual flattening of the curve, particularly in the front end out to about 10 years.

Source: Bloomberg, CRT, Federal Reserve, Goldman Sachs