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Rate Hike is coming....but not yet

ResponsiblyIrresponsible
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9/15/2015 1:49:24 PM
Posted: 1 year ago
The Fed is meeting on Wednesday-Thursday, and some--though fewer than a month ago--anticipate that it might raise its target funds rate from 0 to 25 bps to 25 to 50 bps. At present, many FOMC members who have spoken on this have casted an aura of "uncertainty": i.e., they haven't made up their minds, and don't plan to until Thursday.

Here are my predictions. Read me now, and quote me later:

a) The Fed will not raise interest rates on Thursday.
b) Median SEP projections for inflation, RGDP, and the funds rate path will be revised downward.
c) They will move in December, insofar as headwinds from China abate in relative terms, dipsh1t Republican congressmen don't shut down the government, inflation and wage pressures remain *as they are*, and Greece--or something else on the "list of things that might explode"--doesn't explode.

I'll break down my reasoning and then discuss what they *should* be doing.

a) The Fed has a history of responding to a severe tightening in financial conditions. This is not to say, contrary to what dipsh1ts in the financial media (Peter Schiff, etc.) or permahawks like Jeffrey Lacker tell you, that the Fed is *responding* to financial volatility. Financial markets, though relatively efficient (which, in layman's terms, merely means they factor in all available information into pricing assets, which doesn't obviate corrections, though enables arbitrage absent balance-sheet constraints), move in response to news and invariably bet on impending rate cycles. Sometimes bets are preemptive, in which case the ex-post-facto market response is different than you might expect.

Look at it this way. Stock prices are inversely correlated to returns, and thus to the discount rate (or required return) used to value future cash flows. A rise in the risk-free rate--basically set by the fed (think of it as the fed funds rate or a short-term Treasury bill)--raises the discount rate. To make it simpler:

PV = P0 = D1/(1+k) + D2/(1+k)^2 +D3/(1+k)^3 + (DnPn)/(1+k)^n]

That's the intrinsic value of the stock, which for the sake of argument we'll assume is the end goal -- or where we end up after uncertainty over possible policy surprises abates. In this case, "k" is required return, "n" is the amount of years forward we're discounting back to the present, and D(t) corresponds to dividends over varying time periods.

Here's k:

k = rf + Beta * (Rm - Rf)

rf is the risk-free rate, Beta is a regression coefficient relating stock returns to market returns, and Rm is the expected market return.

The punchline? Varying rf varies "k" *and* the risk premium (Rm - Rf), so adjusting Fed policy *will* tend to move stock prices downward. Granted, prices are regularly based not on observable, ex-post real rates, but on expected, ex-ante real rates, which is why we see stock prices move. In general, this is a natural correction.

Now, the recent stock-market volatility is arguably different. The Dow doesn't drop a 1000 points every other week, nor does it fluctuate like a roller coaster on crack. Indeed, there's uncertainty around rate cycle changes, but not like this. Some of it might be uncertainty over a Fed move, but fed funds futures--market expectations of future risk-free overnight rates--suggest that rates won't gravitate upward until at least later in the year (November/December), with a higher probability on them staying near zero until, say, January. Barclays even moved its expected rate hike from September to March 2016 after the "volatility," which I think is jumping the gun. The problem isn't the volatility. That's normal. The problem is the underlying source of the volatility--and that's weak fundamentals in China, the pass-through to lower commodity prices, and the impact on earnings in the U.S. Hell, Goldman Sachs just projected $20 a barrel oil in about a year. That's crazy. To suggest that this is invariably a tailwind--though it's starting right around now to be less of a headwind--is to be lamentably ignorant, both about the events of the past eight months and about the underlying transmission. Again, this sh1t is complex. Think Dunning-Krueger effect: if I don't know, you probably don't know either.

So, they'll look through "volatility," but not through a severe tightening in financial conditions: higher risk spreads, lower inflation expectations, higher policy uncertainty, and to a lesser extent falling share prices. There's no reason to freak out and hike *now*, lest they scare financial markets about their underlying reaction function (e.g., "We care too much about the NAIRU we've calculated, forecast uncertainty be darned, and have blind faith in the Phillips curve, even though our inflation forecasts have been dead wrong for years).

b) This one is just a given. Potential growth is probably far lower than they've expected because the productivity numbers have come in exceptionally weak, and growth over the past few years revised down. Much like Japan, though, employment still is growing rapidly, because slower productivity means that we use labor slack at a faster rate. Inflation will be low, irrespective, because of inertia, price rigidity, overly tight money, and the pass-through from an appreciation in the dollar, though that transmission is much more subtle than many believe , says a recent Jackson-Hole paper, due to the fact that most of our foreign transactions are denominated in dollars.

c) Irrespective of the dipsh1t teabaggers doing something stupid--austerity, demanding a shutdown unless we defund Planned Parenthood over highly-edited videos, etc.--or a worsening of economic conditions abroad, the Fed will follow through. This is because the Fed perceives credibility differently than you and I might. In many cases, they follow the market.

Let's say that I offer to perform a project for you. You don't give me a specified timeframe because you value over anything else the best finished product possible, but acknowledge that there might be a number of factors out of both of our control--let's say our supplier is a douchnozzle, or it takes a long time for me to acquire financing, or something--might serve as bottlenecks in the process. Irrespective of these uncertainties, I assure you that I anticipate the project will be down by year end, but I can't make a definitive promise due to things out my control.

Now, you'll note the qualifier there: I didn't promise you I would finish this project by year end. I told you that I anticipated that I would be able to finish it by year end, should conditions out of my control allow me to do so. In other words, my promise to you was state dependent, and it would not in any way violate my commitment to you if I didn't finish by year end, especially if the reason for not finishing was that conditions didn't allow me to complete the project in the maximally optimal way.

If I turned the project into you, however, and it was crap, you would probably never hire me again: my work was sh1t, and you told me you valued quality. My credibility would be tarnished. In other words, as a normal person you valued quality over timing.

The markets, however, value timing over quality. In many cases, this is because they're fickle, unsophisticated, and highly ignorant (think of Peter Schiff or Ron Paul, and acknowledge that many hedge-fund guys actually believe this sh1t). They fundamentally misinterpret the simplest of conditional commitments. I never promised to finish the project by year end in the same way the Fed never committed to raise rates by year end: I told you that I anticipated conditions might develop in such a way so as to *warrant* that concluding step. My credibility shouldn't dissipate from this, but in the eyes of the market, they'd think I was full of sh1t if I *didn't* actually liftoff, which is a problem because their unwillingness to properly price long-term assets in line with the Fed's path will *already* cause arbitr
~ResponsiblyIrresponsible

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ResponsiblyIrresponsible
Posts: 12,398
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9/15/2015 1:50:37 PM
Posted: 1 year ago
cause arbitrage like you wouldn't believe.*

tl;dr: Institutional investors are fcking stupid, the Fed won't raise rates this week, stop watching CNBC--they're all lamentably ignorant--and stop believing everything you read about overly complex issues that not even people, like myself, who read about this sh1t know or understand fully.
~ResponsiblyIrresponsible

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TheProphett
Posts: 520
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9/15/2015 1:55:14 PM
Posted: 1 year ago
At 9/15/2015 1:50:37 PM, ResponsiblyIrresponsible wrote:
cause arbitrage like you wouldn't believe.*


tl;dr: Institutional investors are fcking stupid, the Fed won't raise rates this week, stop watching CNBC--they're all lamentably ignorant--and stop believing everything you read about overly complex issues that not even people, like myself, who read about this sh1t know or understand fully.

Stop watching CNBC.... LOL
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ResponsiblyIrresponsible
Posts: 12,398
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9/15/2015 1:57:12 PM
Posted: 1 year ago
At 9/15/2015 1:55:14 PM, TheProphett wrote:
At 9/15/2015 1:50:37 PM, ResponsiblyIrresponsible wrote:
cause arbitrage like you wouldn't believe.*


tl;dr: Institutional investors are fcking stupid, the Fed won't raise rates this week, stop watching CNBC--they're all lamentably ignorant--and stop believing everything you read about overly complex issues that not even people, like myself, who read about this sh1t know or understand fully.

Stop watching CNBC.... LOL

I'm serious, lol.

Granted, a few of them aren't so bad. Steve Leisman is pretty insightful, for instance.. but you see regulars chanting that they were "for a rate hike four years ago," without the slightest self-awareness or humility over how wrong they are, red flags should start springing up.
~ResponsiblyIrresponsible

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ResponsiblyIrresponsible
Posts: 12,398
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9/18/2015 2:38:57 AM
Posted: 1 year ago
Let's see how my predictions panned out..

a) The Fed will not raise interest rates on Thursday.


This indeed was the case.

b) Median SEP projections for inflation, RGDP, and the funds rate path will be revised downward.

Rate path got pushed outward, and inflation forecasts were revised down. RGDP was revised up for this year and down for the next two years.

c) They will move in December, insofar as headwinds from China abate in relative terms, dipsh1t Republican congressmen don't shut down the government, inflation and wage pressures remain *as they are*, and Greece--or something else on the "list of things that might explode"--doesn't explode.

This is probably true as well. Yellen expressed a whole lot of faith in the Phillips curve during her press conference and said that global and financial developments *do not* change her outlook, but only add to the uncertainty surrounding her forecast.
~ResponsiblyIrresponsible

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Sarra
Posts: 288
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9/25/2015 1:12:40 PM
Posted: 1 year ago
At 9/15/2015 1:50:37 PM, ResponsiblyIrresponsible wrote:
I've heard mention of the Reps shutting down the government over something petty recently. Hypothetically, if interest rates were raised, would they be raised by 0.25%, 1%, or something else?