The Fed is responsible for implementing monetary policy to promote maximum employment and price stability in the US economy. It does so through three main tools: conducting interest rate hikes or cuts, quantitative easing or tightening and lastly via managing market expectations through either their commentary or published forward interest rate expectations (known as the “dot plot”). By raising or lowering the interest rate, the Fed can influence borrowing costs throughout the economy. As a general rule of thumb, higher interest rates make borrowing more expensive and slows economic activity and inflation while lower interest rates can be a catalyst for investment activity.   Investors need to ask whether that expectation accurately reflects the reality that eventually ensues or does the path of Fed rate hikes/cuts actually just follow a random walk down Wall Street? Market commentators keep a close eye on the Fed dot plot and commentary to form views on which direction the Fed may alter Monetary Policy over the coming months, with statements like “the Fed is expected to cut rates by 50bps during the next 6 months” being commonplace in financial media.    At Prescient we follow the data to test whether what may seem as commonsense by most market commentators is the actual path of rates as the Fed and the market project, or should they be used with care when making decisions? Figure 1 below illustrates a time series analysis of the relationship between the Fed’s guidance, the market’s expectation (valued via market forward pricing contracts) and the Federal Funds Rate at each point in time. At first glance, it would seem that the three series track quite closely, albeit with some disconnects during periods of steep hiking or cutting.

Sources: Prescient Investment Management, Bloomberg, Federal Reserve (as at 13 June 2024)

 

Digging deeper, Figure 2 below is a density plot showcasing the difference between the Fed's projected rates and the Federal Funds Rate observed over time. Whilst the distributions are centred around zero, initially indicating an absence of systematic bias in the forecasted rates, the tails of the density plot indicate that there certainly are periods where both the market and the Fed dot plot are to be taken with a pinch of salt. If anything, the market has generally been more correct than the Fed in recent times.

 

Sources: Prescient Investment Management, Bloomberg, Federal Reserve (as at 13 June 2024)

 

Ultimately, the Fed’s guidance is influential as it is closely monitored by markets. Even when comparing interest rates in the United States and in South Africa, there is a clear tracking relationship of US rates by the SARB. However, research indicates that the Fed does not accurately forecast the future path of interest rates, and this should be taken into consideration when predictions around domestic interest rates are made as well.

Whilst the market’s expectations have been slightly more accurate in comparison, they are by no means spot-on. 

In summary, the next time you hear a market commentor coming out with 100% conviction that “the Fed is going to cut rates by 50bps” remember to always question whether market commentary is accurate before making financial decisions based on it. 

At Prescient we do just that - always trying to consider all data to give clients the investment advantage. 

 

Disclaimer

Prescient Investment Management (Pty) Ltd is an authorised Financial Services Provider (FSP 612).

Please note there are risks involved in buying or selling a financial product, and past performance of a financial product is not necessarily a guide to future performance. The value of financial products can increase as well as decrease over time, depending on the value of the underlying securities and market conditions. There is no guarantee in respect of capital or returns in a portfolio. No action should be taken on the basis of this information without first seeking independent professional advice. Graphs are provided for illustrative purposes only.

 *FAIS representative acting under supervision.

This document is for information purposes only and does not constitute or form part of any offer to issue or sell or any solicitation of any offer to subscribe for or purchase any particular investments. Opinions expressed in this document may be changed without notice at any time after publication. We therefore disclaim any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable directly or indirectly to the use of or reliance upon the information. For more information visit www.prescient.co.za