Leveling the Playing Field

October 19, 2015

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Short and sweet newsletter this week in the midst of a relatively benign week for rates, with a
general trend lower across the curve but nothing too dramatic. The T10 broke 2.00% on
Wednesday and closed at 1.97%, but rebounded Thursday morning after a stronger than expected
jobless claims report.
This week should be relatively quiet as week, with the biggest potential movers likely coming
from Treasury auctions. The Fed will go dark on Wednesday, one week ahead of the next
FOMC meeting. The early week speakers represent both hawks and doves, so we are unlikely to
gain any clarity from these speeches. We cant imagine a scenario where a Fed speaker remark
changes expectations that the Fed will remain on hold at the October 28th meeting. Any
comments that this will be a live meeting will be largely dismissed.
We dont see a lot of reason for yields to push higher this week as traders typically sit on their
hands and square up positions ahead of big events like an FOMC meeting. The market feels
pretty balanced right now on the back of last weeks stable run. With yields basically sitting
right in the middle of recent trading ranges we dont see much on the horizon this week that
would send rates off dramatically in one direction or the other. Technical curve steepeners (like
5/30s) tested recent highs early in the week before retracing, also suggesting it will take a
significant event to break through those high levels.
We should start to hear more and more about the debt limit ceiling in the coming weeks. The
government will run out of money in early November and be basically forced to operate out of a
petty cash drawer. This raises the risk that the government wont be able to pay federal workers
or in a dramatic outcome, bond holders. The White House reiterated last week that it will not
negotiate with Republicans on this subject, setting the stage for a Boehner-less showdown.
While it seems incredibly unlikely even the leaderless Republicans would risk the political
fallout in an election cycle, markets cant completely discount that outcome. This should also
help keep a lid on rates.
Given the quietness, we thought wed use this time to very briefly cover the FOMC voting
composition expected at year end, when some voting members rotate out and others rotate in.
The bottom line is that a very dovish FOMC will become even more so.
The FOMC will be more heavily divided between doves/hawks with the neutral category
losing two voters. Although two neutral members will be replaced by two hawks, the overall
percentage of dovish members will still increase from 53% to 60% in 2016.
We suspect the hawks will make more noise next year, but wont have enough sway to set
policy.

FOMC Composition

2015
Fed Member
Janet Yellen
William Dudley
Lael Bainard
Stanley Fischer
Jerome Powell
Daniel Tarullo
Charles Evans
Jeffrey Lacker
Dennis Lockhart
John Williams

Position
Chair, permanent
New York, Vice Chair, permanent
Governor, permanent
Governor, permanent
Governor, permanent
Governor, permanent
Chicago
Richmond
Atlanta
San Francisco

Views
Dove
Dove
Dove
Dove
Neutral
Dove
Dove
Hawk
Neutral
Neutral

2016
Fed Member
Janet Yellen
William Dudley
Lael Bainard
Stanley Fischer
Jerome Powell
Daniel Tarullo
Eric Rosengren
Loretta Mester
James Bullard
Esther George

Position
Chair, permanent
New York, Vice Chair, permanent
Governor, permanent
Governor, permanent
Governor, permanent
Governor, permanent
Boston
Cleveland
St. Louis
Kansas City

2015 FOMC Composition

Dove

Neutral

Hawk

Views
Dove
Dove
Dove
Dove
Neutral
Dove
Dove
Hawk
Hawk
Hawk

2016 FOMC Composition

Dove

Neutral

Hawk

Fed Funds Futures Rate Hike Expectations

-

6% probability of a hike on October 28th

32.3% probability of a hike in December
First meeting with a probability above 50% is March 2016
December 2016 has a 51.7% probability that Fed Funds is between 0.50% - 1.00%, with
a 11.9% probability that Fed Funds is above 1.00%

The Bloomberg screen capture below shows current probability of a hike at each FOMC meeting
for the next twelve months (we highlighted some of the key takeaways above). But look at the
horizontal lines across the bottom of the screen. Its a bit tough to read because I couldnt figure
out how to blow it up, but it shows the historical probability of a hike at the October 28th meeting
over the course of 2015.
The red horizontal line shows the probability of a 0.25% rate hike at this months meeting. It
was roughly 50% (top of the graph) all year long until very recently, when it collapsed to nearly
0%.
The green horizontal line shows the probability of Fed Funds being between 0.50% - 0.75% after
the 10/28 meeting (in other words, one hike before then and one hike at that meeting).
Expectations for two hikes have crashed to 0%.

Here is what the market expects LIBOR to average in each calendar year for the next five years.
2016 average: 0.48%
2017 average: 0.97%
2018 average: 1.41%
2019 average: 1.73%
2020 average: 1.97%
The Fed is doing its best to prevent expectations from backsliding. Dovish Vice Chairman
Dudley said it would still be appropriate to hike this year if his forecasts are met. Hawkish
Cleveland Fed President Mester (non-voter) said last week it was appropriate to depart from
ZIRP and that 70k-120k jobs gained each month would keep the unemployment rate steady.
Just as importantly, she indicated that the Fed must keep additional QE in mind as an option in
the future and is not opposed to pushing FF back to 0% after a liftoff if conditions warrant.

There you have it even the hawks are starting to set the stage for additional QE in the face of a
rate hike.

Operation Twist anyone?

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