Fed rate decision: 'dot-plot' more important than the hike itself

Outlook:

You might not know it from the headlines, but we do get some US data today, including housing starts. The Reuters survey gets a forecast of 1.135 million (annual pace) from 1.135 million in Nov and 1.060 million units in Oct. This will be the 8th month of gains. Permits, however, will probably dip to 1.150 million from 1.161 million. Separately, industrial production probably fell 0.1% in Nov for the third consecutive month.

Losses in manufacturing are a key factor for some analysts to imagine the Fed might not hike today, added to the too-strong dollar and some weakness in consumer spending. Market News reports that one economist (at Mizuho) says we shouldn’t count our chickens before they hatch—the Fed could defer the hike into next year. The line between crank and brilliant contrarian can be very fine, but probably not this time. The Fed would get buckets of scorn if it abruptly defied its own guidance at the last minute. Another analyst told Market News that today marks the 7th anniversary of ZIRP and references the Bible—seven years of fat and seven years of lean. Is it really the beginning or end of a cycle? Who knows, but "major transitions are usually accompanied by fear and trepidation..."

We are going along with Fed guidance and the majority of analysts in saying the Fed will act today, although surveys indicate the probability remains less than 100%. The WSJ gets an 87% probability and the CME’s Fed funds futures showed a 83% probability as of Monday.

As we all know, more important than the hike itself is the dot-plot. The Sept dot showed the Fed collectively sees rates at 1.375% by year-end next year, implying four hikes of 0.25% each. Adding in the later years, the rate should be 2.625% at the end of 2017 and 3.375% at the end of 2018. The long-run average is 3.5%, so 2018 will be a nearly full return to “normal.”

As we reported yesterday, this may not actually be the correct concept of “normal.” But never mind. First we have to get over the hump of the first hike and whether it sets off a frenzy of contagious fear and loathing, So far it looks like the move has been so long awaited that it’s all over except the shouting, but you never know. Then we can move on to the new dot-plot. Everyone will be dying to see how much lower it falls this time. Fed officials won’t admit it, but a lowering would be implicit recognition that oil and other commodity prices are in a longer-term downswing and inflation expectations must accordingly be lowered.

In this context, note that Iran may be able to begin exporting oil in the first quarter and with the US about to be able to export, too, there is no end in sight for the supply glut. But what if the Saudis abandon their market-share strategy and start curbing production? It’s oversimplified, to be sure, but inflation in the US depends on Riyadh.

If we assume the Fed sees oil prices lower for longer, the dot-plot has to be lower for longer, too. This is why we feel skeptical about forecasts for the dollar to resume its upswing based on rising yields. Capital Economics, for example, sees the 10-uyear rising to 3% “primarily because investors are underestimating — as they have tended to do at the outset of previous Fed tightening cycles — the amount by which the federal funds rate will be raised, as wage and core inflation pick up.” The FT report goes on to say Capital Economics sees the yield differential widening as the BoJ and ECB ease further, so the dollar gains. Its forecast is 0.9500 for the euro and ¥140 for the yen by year-end.

Moreover, equity markets in Japan and Europe will outperform the US and emerging markets will come roaring back as “worries about China’s economy recede and the slump in commodity prices comes to an end. Fed tightening will not rattle the EM stocks “whose valuations are typically not stretched.”

Oh, dear. This article was written by the guy who does the daily Global Markets Overview for the FT (Jamie Chisholm) and we think he is one smart cookie. And there is some possibility that Capital Economics has the scenario right—US yield back to 3%, China okay, commodity prices firming.

But we doubt it. For one thing, the Fed is fairly frightened. Look how spooked they got in September. Yellen has gone to great lengths to emphasize the word “gradual,” to the point where “dovish hike” became a new phrase. The dot-plot this time must be lower. It may be true that the market is underestimating the Fed by a wide margin, but it would take a full-bore hawkish Fed today to get the market to believe in 1.375% by year-end next year. The market may lift its forecast from 0.85% to 1%, or two more hikes, but not three or four. And that’s assuming the dot-plot keeps the 1.37% this time.

Another reason to doubt the Capital Economics scenario is that China can always surprise. Worries have receded for the moment but there is a giant upheaval going on in the transition from a command economy to a more market-oriented economy and from a focus on big industry exports to domestic demand. To expect a smooth path is to hold unrealistic expectations.

And as for commodity prices starting to rise again, we have no sign of that. We know that a price fall is about to end when analysts start talking about the marginal cost of production. This holds true for tin, copper, oil, iron ore, and anything else. We get some marginal cost quotes once in the while for oil but so far, the Jimmy Rogers rule is holding. As we say above, it ain’t over until the fat lady sings and the fat lady this time is the Saudi oil ministry.

With all this in mind, wither the dollar? We are getting a little pre-Fed bounce, but we are very worried it won’t last. The dot-plot will likely kill it. If you are long dollars, you should get out before 2 pm. We could have a gigantic dollar sell-off. This is risk-management more than it is a forecast.