Two friends discussing market trends of the week got into an interesting conversation.
Ram: In last Wednesday’s policy meeting, the US Fed did not raise interest rates, signalling a pause. But still, stock markets across the world from Nasdaq Composite in the US to Nikkei 225 in Japan and the Nifty 50 in India, fell and bond yields spiked! I thought a pause in the interest rate hike cycle was actually positive for markets. Not able to understand this disconnect between Fed decision and market reaction.
Veena: Ha! The devil was in the details. Did you see the Dot Plot?
Ram: No, what is it?
Veena: The US Fed holds eight scheduled Federal Open Market Committee (FOMC) policy meetings in a year, and in four of these it releases, along with its summary of economic projections (SEP), something called a ‘Dot Plot.’ These are released in March, June, September and December meetings.
The Dot Plot is a graphical representation of interest rate expectations of the voting and non-voting FOMC members. Currently, there are 19 FOMC members and the Dot Plot indicates each member’s expectation of where they expect the central bank interest rate to be at the end of the current year as well as by end of 2024, 25 and 26. It is important to note that the Dot Plot does not reveal the names of the members.
For example, the latest Dot Plot released on Wednesday indicates that 12 FOMC members expect the benchmark Fed Funds rate to be between 5.5 and 5.75 per cent (around 5.6 per cent) by end of 2023 (implying one more rate hike this year), while 7 members expect it to be between 5.25 and 5.5 per cent (which happens to be the current Fed Funds rate). However, market participants have no clue who these 12 members are who expect 25 bps hike by end of 2023. If the 12 include most of the voting members and also the influential Fed Chairman, Jerome Powell, the probability of rate hike is much stronger.
Nevertheless, in the absence of finer details like this, investors take the cue from the interest rate levels where the dots are crowded (implying more of consensus or wisdom of the crowd view).
Ram: Hmm, interesting…but I still don’t understand why markets were spooked.
Veena: Well, while the Fed paused on its hiking cycle, its Dot Plot reflected hawkishness. Its Dot Plot now reveals that based on median of the Dot Plot for 2024, the interest rates are likely to be only 50 bps lower than 5.6 per cent projected median rate (consensus view) for end 2023. Earlier in June, the Dot Plot projection showed that the interest rates in 2024 would be 100 bps lower than end 2023 level. That was a little bit of a shock for a market that has been constantly betting on interest rate cuts starting early this year, only to get pushed back each time.
So, the market reaction could be a reflection of market participants addicted to investing in risk assets in anticipation of lower interest rates, finally coming to terms with the probability that interest rates may remain higher for a prolonged period of time or the ‘higher for longer’ theme Jerome Powell has been stressing on is for real!
Do keep in mind that markets don’t just focus on the interest rate policy decision, but also on information provided by Central Bankers, like the Dot Plots. Some times, even a few sentences uttered by a Central Banker with conviction can move markets significantly. For example, just three words ‘Whatever it takes’ from the ECB Chairman of 2012, Mario Draghi, on ECB’s commitment to preserve the Euro, was strong enough to boost market confidence that the Euro Zone crisis could be resolved at a time when many believed the Euro would break.
This time, post the release of the Dot Plot, the press conference by Powell did nothing to assuage the hawkishness implied by the Dot Plot. Hence the negative market reactions globally.
Ram: Ok, so do interest rates follow the path as indicated in the Dot Plot?
Veena: Not at all. For example, the Fed Dot Plot released in September 2021 indicated the Fed Funds rate could be at 0.3 per cent by end of 2022 and 1 per cent by end of 2023. The actual rate at end of 2022 was 4.375 per cent, and will likely be 5.62 per cent by end 2023.
Ram: Wow! Then how do markets factor this information?
Veena: Ha! Markets have their own way of discounting information. And maybe, based on persistency in inflation, energy prices moving up, GDP growth remaining better than expectations, markets believe the Fed forecast is highly probable this time. But as John Kenneth Galbraith said, ‘the only purpose of economic forecasting is to make astrology look respectable’. Let’s see whether the Fed members fare better than astrologers this time.