Summary

  • The FED is pretty bad at economic forecasting.
  • The expected size of the rate hike to occur in 2015 has been significantly reduced through 2015.
  • Futures on federal funds rates now imply that the market expects rates will rise sooner, but then will rise in a more gradual manner in comparison to expectations in December 2014.
  • The expected rate of increase of the federal funds rate is much more subdued than paths of any historical rate increases.

 

We’ve discussed before about how the FED is notoriously bad at economic forecasting.

At the Federal Open Market Committee Meeting at the end of 2014, 15 out of the 17 participants predicted that the Federal Funds target rate would increase in 2015. At that time, the median end of 2015 forecasted rate was 1.125% with participants ranging from 0.125% to 1.875%.

As of September, 13 out of the 17 participants still anticipated a rate hike this year, but the expected range has condensed significantly: the median forecast was revised to 0.375% with a range of -0.125% to 0.875%. Yes, one member pegged their forecast in the negative rate territory.

Target Rate

At their recent meeting in October, they yet again pushed off any rate increase, leaving the last possible chance to get one in during 2015 for the December meeting.

Now we said that the FED is bad at forecasting, but we don’t mean this as a slight to them. Could we do any better at guessing where interest rates would go? Probably not.

It is no surprise that the FOMC members have clustered their estimates more recently than at the end of 2014. After all, we only have about 2 months left in the year.

The consensus appears to be a 25 basis point (bp) increase in December, and if history is an indicator of typical rate increases, hikes generally come in that increment, at least at the beginning of a rising rate period. In the 31 rate increases since 1990, only 5 of them have been larger than 25 bp.

Nevertheless, with only one more meeting in 2015, having a 1% spread in such a weighty decision still makes the near future of interest rates far from certain.

As humans, we are subject to many behavioral biases, especially when forecasting. Even in a group of 17 experts, biases can still play an important role.

While we obviously do not believe that markets are totally efficient, we do believe that they contain very useful information. A market, in theory, should also reduce some of the biased estimates that we get from a small subset of humans.

For the market’s take on interest rate increases, we can turn to futures prices on the 30 Day Federal Funds Rate from the CME Group.

Implied Fed Funds Rate

We can see that the market has revised its predictions over the course of the year, as well, moving from a December 2015 implied rate of 60 bp as of December 2014 versus a rate of 20 bp as of October 2015.

By looking at relative rather than absolute time, we can see that the implied speed of any increase has also shifted.

Implied Fed Funds Rate - Relative

Relative to at the end of 2014, the rate increase is now expected to happen sooner but more gradually.

So what happened last time rates increased?  With the current environment of zero interest rates approaching the 7 year mark, rising rates seem like a thing of the past.

Historical Paths of Rate Increase

The market forecast for any rate increase is clearly subdued from a historical perspective. The prices currently imply a 43% probability of an increase in December. Compare that to a 78% likelihood after the May 2004 FED meeting before rates began to rise that June.

Until we get out of the period of worrying about rising rates and into the period of actually experiencing them, we won’t know exactly how an increase will play out. Forecasts from experts and implications from the market have been wrong in the past, and we fully expect them to miss the mark in the future.

But that is not necessarily a bad thing.

By focusing on a reactive approach to rising rates, rather than relying on speculations as to when and how rates will increase, we can focus on adapting to market changes as they unfold. While that approach, by definition, won’t anticipate the next rate increase, we believe that there is more to gain over the long term from reigning in our irrational tendencies that can sway our forecasts, especially during very unique economic periods.

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn.

Corey is a frequent speaker on industry panels and contributes to ETF.com, ETF Trends, and Forbes.com’s Great Speculations blog. He was named a 2014 ETF All Star by ETF.com.

Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University.

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