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Not Here Yet

Posted on February 17, 2015

“I think the time is coming, but it’s not here.” - Fed Governor Jerome Powell

2015-02-17_empty_train_tracks.jpgOver the past several years we have given the Federal Reserve its fair share of coverage on this blog. Our preoccupation with the US monetary system might be considered overkill in a more normal economic environment, but given the hands-on interventionist approach of our policy makers since the financial crisis we believe the attention has been warranted. Our treatment of this topic reached fever pitch in the fourth quarter of 2013 when we sponsored a pre-screening of the documentary Money For Nothing here in Colorado Springs prior to its national release. During this time we also wrote a four-part Insight series called “Fed Ed” to provide our clients and colleagues with a high level summary of the history of the Federal Reserve as well as the ins and outs of its purpose and function.

Fed Ed: The Genesis
Fed Ed: Frankenstein’s Monster
Fed Ed: Pulling Back The Curtain
Fed Ed: Mood Management

The Fed’s policy strategy since the financial crisis can be boiled down to two primary components. The first step was to lower short-term interest rates to zero; the second step was quantitative easing (“QE”). The nuts and bolts of both of these policy tools are explained in detail in the final two installments of our Fed Ed series linked above, so we won’t attempt to unpack them here. Now that the Fed’s third, and supposedly final, round of quantitative easing is concluded, the next logical step is to begin reversing its zero interest rate policy by making the first of what will be a series of short-term interest rate hikes. Predicting when the first rate hike will take place, despite being a near impossible task as we will show, has been the source of endless discussion in the financial media in recent months.

But before we address the forecasts, let’s examine some of the reasons the Fed may or may not want to begin raising interest rates. First of all, zero percent interest rates and quantitative easing would both be considered extreme, unconventional policy moves by any central bank. While the long-term positive and negative consequences of these policies will continue to develop over time, the Fed is understandably anxious to be seen as starting down the path of “normalizing” its policies. In a similar vein, many would argue that it’s high time to begin reloading the policy gun so to speak. The higher interest rates are when the next recession hits, the more rate cut bullets the Fed will be able to fire in order to stimulate credit expansion and counteract a slowing economy.

Perhaps the most glaring champion of an interest rate hike, however, is the ever-improving US jobs market. A rolling 6-month average of monthly payroll gains continues to march upward (see chart), hours worked is finally growing and the total number of nonfarm job openings is now higher than since before the financial crisis. At 5.7% the unemployment rate is far below where the Fed originally set its targets when venturing out into the uncharted territory six years ago. For a policy making body mandated to address two main macroeconomic data points (inflation and unemployment), this seems like a substantial reason for beginning to consider a rate hike. Note: We realize the headline unemployment rate should be taken with a grain of salt (see Lack of Participation), but the fact remains that the labor market is making steady improvements at the margin – something the Fed was waiting to see.

2015-02-16_Job_Gains.png

So while the general health of the economy, and particularly the labor market, is seen as supportive for a rate hike, there are also plenty of objections to that course of action. For one, the US Dollar has already strengthened considerably and is only poised to get stronger if and when the Fed begins hiking. Believe it or not, most other central banks around the world, many of which are battling deflationary forces, are planning on easing policy in 2015. Further strengthening of the Dollar could hurt exports and threaten global profits generated by US multinational companies. Furthermore, many market pundits, and even some Fed officials, have pointed out that there is no reason to rush towards a higher interest rate policy as long as inflation appears to be under control. As the chart below shows, the Fed’s preferred measure of inflation remains under target.

2015-02-16_Core_PCE.png

So where does all this leave us, and when will the Fed make its first rate hike? If Mr. Market is to be believed, the Fed should makes its first move at either the June or September meeting. The chart below plots the implied Fed Funds rate at future dates based on current prices of futures contracts tied to that interest rate.

2015-02-16_FedFundsFutures.png

That said, how much stake should be put in Mr. Market’s predictions? Not much. Let’s take a look at the recent track record of these futures traders as well as the Congressional Budget Office in predicting the Fed’s next move. The chart below, provided by Deutsche Bank Global Markets Research plots the forecasted path of interest rates as predicted by Fed Funds futures at various points in time over the past seven years. These forecasts are represented by the black dotted lines all of which reveal that, aside from the very first forecast on the chart, the futures market has been incorrectly predicting an imminent rise in short-term rates since before the financial crisis ever really got going! The red line, of course, is what short-term rates have actually done over this time period.

2015-02-17_db_chart.png

The Congressional Budget Office does not look any better. The chart below is courtesy of the Wall Street Journal and reveals a very similar dynamic as the one above. If early CBO forecasts were to be believed, short-term rates would have been expected to be encroaching on 5% by the time 2013 rolled around.

2015-02-17_cbo_chart.jpg

John Mauldin recently captured the difficulty of forecasting when he penned, 

Forecasting is a singularly difficult task and is more often than not fraught with failure. …The world has grown so complex that it is singularly difficult to understand the interrelationships of the million-odd factors that determine the outcome of an economy. 

We completely agree with these comments, thus our own perspective on the question of when the Fed will begin to raise rates would more closely echo the sentiments of Fed Governor Jerome Powell in the opening quote of this post. We think the time is coming, but it’s not here yet. Beyond that, we’ll leave the prognosticating to the forecasting “experts” who have shown us time and time again that trying to guess when the Federal Reserve will hike short-term rates is a fool’s errand.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.