In a previous post we looked at how the futures markets were pricing in the eventual beginning of Fed tightening.
Yeah, we know — it’s way too premature to be discussing this.
But stick around, because recently we came across an interesting paper by RBS that says the when matters a lot less than the how of tightening — referring specifically to the speed.
RBS strategists start by modeling the market-expected path of the federal funds rate. They arrive at a basic short-rate model using the swap/LIBOR yield curve as a proxy for the rates, embedding their model with assumptions about volatility and risk and convexity premiums derived from the markets for options on Eurodollar futures. (Click here for more on how to do this, if that’s your thing.)
Here’s what they came up with:
Conclusion: it’s a sloooooow move up, at least by historical standards, and that’s not a hopeful sign:
The striking feature of this path over the 10 year period displayed is not when tightening begins (Q1,2012) or where it ends (4.17%) – it is its slow pace of around 10 bp per quarter! Even on the steepest part of the curve around 1.5 years out, the Fed is expected to hike only 33bp per quarter, or a bit more than a 25bp hike every other meeting.
What kind of economic future is consistent with the current structure of the yield curve? Two scenarios come to mind: another recession, most likely around the middle of the decade or a prolonged period of Japan-style stagnation. Importantly, the current yield curve is inconsistent with more optimistic scenarios.
Great. Of course, as RBS rightly admits, this is a probabilistic estimate and, let’s face it, an abstract exercise to begin with.
The strategists are aware of this and also try to model some alternative pathways to assess the potential impact on the rest of the yield curve all the way out to thirty years. Here are the three alternative scenarios they test, and how each one played out (emphasis ours):
1) In early-fast, the Fed tightens in Q1, 2012 and moves at a pace of 50-75 bp per quarter until the FF rate reaches the economically neutral rate of 4.5%.
2) In late-fast, the Fed waits until Q3 2012 before tightening and then moves at a pace of 50-75 bp per quarter before leveling off at 4.5%.
3) In early-slow, the Fed moves in Q1, 2012, but only slowly raising the FF rate 25 bp per quarter, eventually leveling off at 4.5%. …
Here we start with various paths for the FF rate (early-fast, etc) and construct the yield curve each implies. We then compare the swap curve corresponding to each scenario with the existing yield curve. The differences, seen in Figure 3 below, show how the yield curve would change if the market instantaneously came to believe that Fed was actually going to follow one of these scenarios.
This analysis suggests that the bond market, especially beyond 5yr maturity, is vulnerable to a sell off once the Fed finally begins to tighten. This is hardly news, but the extent of the market’s vulnerability and its dependency on how fast the Fed moves is surprising. In the case of the early-fast scenario 10s rise by nearly 80 bp and 5s by 100 bp; in the case of late-fast, 10s rise by around 54 bp; 5s by around 58 bp. In the case of early-slow, 5s are unchanged while 10s rise by only 20 bp.
And the faster the tightening after the initial move, the greater the intensity of the impact on the belly of the curve in particular, RBS finds.
Many caveats apply here given the assumptions needed and how quickly the expected path of rates can change. But no wonder Bernanke & Co are trying to persuade us that monetary policy should stay looser for longer than many wish.
Full note in the usual place.
Related links:
When will tightening begin? – FT Alphaville
The rise in Fed funds futures rates – FT Alphaville