MBS Day Ahead: Tale of Two Market Watchers--It's Not Complicated

For some of you, the current goings-on in markets will make lots of sense and indeed, further analysis can't help but be redundant.  If that's you, feel free to tune out or simple to use the following to reinforce what you already know. For the rest of you, there's today's commentary.

Hi, welcome.  First of all, let me say that we're all seeing the same economic data.  We can plainly see that several of the key metrics have been tepid and/or declining throughout 2015.  The fact that there's a relative absence of inflation cannon be argued.  Wage growth is elusive and productivity is inexplicably low.  Lots of people have jobs, but there's a general sense that those jobs are lower quality than they used to be, not to mention the throngs of warm bodies exiting the labor force. 

In short, it doesn't FEEL like an economy that should result in a Fed rate hike.  This is true for both kinds of market watchers.  The difference is that one of them knows the Fed is going to hike anyway.

It may be impossible to truly comprehend or explain with logic.  Indeed, I personally base a measurable portion of my Fed assessment on a "feeling" I get from their policy communications in 2015.  There's a sense of urgency and compulsion to raise rates that they've done a fairly awful job explaining.  It might be about any of the following, or a combination thereof:

• They don't see oil prices going much lower than $40, so they reckon inflation will have to pick back up
• They're concerned with the financial stability ramifications of zero rates lasting too long (i.e. risk taking in search for yield)
• They're concerned about bank deposits and/or "savers."
• They're concerned that if the economy starts to slide in the future, they won't have been able to raise rates enough beforehand to have anything to cut in response (the "dry powder" argument)
• They're concerned about the wealth gap and they see zero rates as widening it
• They really think that economy is warm enough to raise rates

They've leaned on the last point more than any, and that's the one that makes the least sense.  From the standpoint of "sunk costs," merely looking at whether the economic landscape justifies a rate hike, here's the most interesting thing I can think to say about the dichotomy of market watchers: If the Fed funds rate were at 4%, does anyone think they would consider hiking?  My goodness no!

And therein lies the problem.  Some market-watchers are considering Fed rate hike prospects as a function of the Fed's mandate (employment and price stability).  Other market-watchers can plainly see that the Fed just thinks 0-.25% is too low.  In other words, there's an unspoken mandate that says 0-.25% is an "emergency rate" that's too low to maintain when economic data isn't catastrophic.  And yes, this is either faulty logic or it bespeaks the Fed hiding its true line of thinking.  "We have to hike because rates are just too low" is one of the silliest things I've heard.  It sounds like an old person who hasn't come to terms with new realities.  It reminds me of folks who were banging the inflation drum in 2010/2011, or the folks who didn't think European yields would turn negative with the onset of QE.

Most market participants have come to terms with the fact that the Fed is going to hike because they want to.  The  Fed's reasons don't necessarily make sense to them, but the Fed's intention is clear.  As such, it was immediately time to start pricing in a December hike after the October Fed Announcement.  As a reminder, that October announcement basically said everything's fine and we're not worried about China any more.  It also specifically mentioned a December rate hike possibility.  The Fed doesn't ever get any more transparent about its future intentions.  It doesn't have to make sense to you WHY they're acting like this, only that that ARE.

Markets get it.  Yields have made their most methodical move of the year toward the important pivot zone in the high 2.2's.  In the chart below, the lower section is the 'absolute change' between each day's closing yields.  The farther from the midpoint, the bigger the gap from the previous close and the more abrupt the movement, in general.  Notice how the most recent move higher has been much less volatile.

Bottom line, the Fed is going to raise rates (unless something unexpectedly atrocious happens) and markets realize it.  As such, they're pricing in that reality in a very orderly manner.  The good news is that there are still bond bulls out there who are interested in buying either when yields get high enough and/or after the hike has happened or fully been priced in.  I don't think we're quite there yet.  Even if we are, it's safer to assume we're not.