Advisory Blog
The Market Thinks It Can Predict What the Fed Will Do. It Can't.

Timely insights on the issues that matter most to investors.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

  • All Posts
  • More
    Topics
      Authors

      Filter Insights by Date:   Start Date   End Date   or  Show recent results
      The article below is presented as a single post. Click here to view all posts.

      By Tom Lee, CFA, Managing Director - Investment Strategy & Research, Parametric

      Seattle - Markets, particularly liquid markets, contain a lot of information, and for that reason most economists agree that we should pay attention to what they can tell us about the broader economy, at least in the short term. But are markets good at predicting everything? When it comes to the Federal Reserve and interest rate predictions, the answer seems to be no.

      The Fed met June 18-19 amid expectations that it will cut rates in the second half of the year. Many market participants believe Fed action is necessary to offset the perceived economic slowdown taking hold in the US and globally. For equity investors, a cut in interest rates is perceived as the elixir that cures all ills. Look no further than the June employment report to see how this plays out.

      Entering June, the market was expecting the US economy to add somewhere in the neighborhood of 175,000 jobs. On June 7 the Bureau of Labor Statistics announced that the US economy added a paltry 75,000 jobs and revised down its estimates for March and April. US stocks rallied after the release of the report, with market participants convinced that the weak results gave the Fed cover to begin cutting rates.

      In fact, it's clear now that the market is expecting the Fed to fully reverse course and cut rates multiple times in the next year. How do we know this? We can observe the market's interest rate predictions through Fed funds futures, which trade in volume every day on the Chicago Mercantile Exchange. Every article I see about potential Fed rate changes points out market expectations by referring to the Fed funds futures market. That's why I found the graph below, originally published by Deutsche Bank and adapted by Parametric's research team, so interesting.

      PPAblog619

      Deutsche Bank looked back at the past 18 years to see exactly how well the Fed funds futures did at predicting what the Fed would subsequently do. Not too well, as it turns out. Our research team expanded the graph back all the way to 1989 and found similar results, as the chart above shows. During the years immediately after the global financial crisis, for example, the market consistently expected the Fed to raise rates, but for nearly seven years it never did. Similarly, once the Fed did start raising rates, in the fourth quarter of 2015, the market repeatedly expected it to slow down. And yet it didn't.

      As we can see on the right-hand side of the chart, circled in yellow, the market now appears to expect the Fed to cut rates by approximately 0.5% to 1% over the next 12 months. Why do we think the market will be better at interest rate predictions now when it's been so challenged at doing so in the past?

      Bottom line: One would expect Fed funds futures—which trade in a market that's deep and liquid—to be more accurate in determining the timing of Fed rate changes. The fact that its interest rate predictions have been consistently incorrect in the past argues, at least in this case, to be cautious about accepting what the market is telling us about Fed policy in the future.