Policymakers often employ a comparative analysis of simple monetary policy rules to assess the implied federal funds rates and inform their decision-making processes. While these rules offer a quantitative framework, it’s crucial to remember the qualitative aspects. The key qualitative element here is that the Fed seems very reluctant to counter market pricing, potentially leading to a situation where the central bank gets cornered by the market price action! This means market volatility could be amplified by forthcoming economic data releases. In a nutshell, Buy Rates Volatility (B.R.V.)!!

At InflectionPoint, the first step in defining our rates strategy is a critical comparison of simple policy rules with the market’s implied pricing of Fed policy actions. This enables us to frame the market-implied macroeconomic regime, challenge market perceptions, and identify potential trading opportunities.

The general form of a simple monetary policy rule is:

it = ρ it-1 + (1 – ρ)[r* + πt + α(inflation gap) + β(activity gap)]

Where:

it is the central bank’s policy rate at time t.

ρ captures the amount of inertia in the policy rule.

r* is the equilibrium real interest rate.

πt is the inflation rate at time t.

α determines the responsiveness of policy to the inflation gap.

β determines the responsiveness of policy to the activity gap.

Imagine these monetary policy rules as a complex puzzle. Each piece represents a variable: inflation, economic activity, the policy rate, and the coefficients ρ, α, and β. While solving this puzzle is essential for understanding economic dynamics, it’s a challenging and somewhat esoteric task. Nonetheless, mastering these monetary policy rules is crucial for developing a robust macro investment strategy at InflectionPoint. Let’s delve deeper into this fascinating subject. Several popular monetary policy rules have been proposed, including:

1. Taylor (1993) : it = r* + πt + 0.5(πt – π*) + 0.5(output gap)
2. Core inflation Taylor (1999) : it = r* + πtCore + 0.5(πtCore – π*) + (output gap)
3. Alternative r* rule : it = ρ it-1 + (1 – ρ) [r*alt + πtCore + 0.5 (πtCore – π*) + (output gap)]
4. Inertial rule : it = ρit−1 + (1 − ρ)[r* + πtCore + 0.5(πtCore− π*) + (output gapt)
5. Bernanke (2015) forward-looking rule : it = r* + πF + 0.5 (πF – π*) + 0.5 (output gap)
6. Orphanides and Williams first-difference rule : it = it-1 + 1.74(πF – π*) – 1.19(ut-1 – ut-2)
7. Low Weight OG : it = 0.91it−1 + 0.09[r* + π* + 1.58(πt+1Q,F − π*) + 0.14 (output gapt+1F)

Let’s examine the Cleveland Fed’s projections based on seven simple monetary policy rules. According to their median forecast, the federal funds rate is expected to be 4.9% by the end of 2024 and 4.4% by the second quarter of 2025. However, there’s a range of possibilities: the 75th percentile suggests rates could reach 5% by the end of 2024 and 4.7% in Q2 2025, while the 25th percentile indicates a lower rate of 4% by the end of 2024 and 3.3% by Q2 2025. This is the path that markets seem to be pricing now!

SOFR fixing is priced at 4.33% for the December meeting and 3.33% for the June 2025 meeting.

Market pricing is broadly in line with what is predicted by the Taylor rule (1993) and the Bernanke rule (2015) based on the Congressional Budget Office and the Cleveland Fed BVAR model key variable forecast, but generally below what most other policy rules seem to suggest.

A noteworthy aspect of the FRBC staff BVAR model – a simple statistical Bayesian vector autoregression model – is that while it’s not the official FED model, we believe it may closely align with the projections of the FED’staff projections. These projections suggest a rather front-loaded decline in interest rates, as evidenced by the Taylor 1993 and Bernanke 2015 models approaching 3% as early as Q1 2024.

A substantial and rapid decline in the federal funds rate to the 3-3.75% range by mid-2025 is aligned with certain market models that forecast a more aggressive Federal Reserve policy. This prediction is primarily driven by rather strong assumptions regarding the expected convergence of inflation towards the Fed’s target, a moderate economic slowdown, and a gradual increase in unemployment. These projections resonate with Chairman Powell’s recent statements, indicating a potential shift towards a more accommodative monetary policy.

We are convinced this central base scenario is based on very fragile assumptions!

Market pricing seems to overstate rate cuts, our analysis suggests a slightly less steep trajectory. The current market pricing might offer opportunities to marginally reduce exposure to overly aggressive rate cut expectations, potentially targeting one or two fewer cuts than implied by the market. The key rationale for this view is relatively more sticky inflation hovering around these levels or just slightly above. The base case barely offers an attractive trading opportunity in my view.

What could disrupt this market-implied outlook? For macro investors, this is – no doubt – the most critical question!

1. A substantial increase in unemployment could necessitate even more aggressive rate cuts, potentially falling well below 3%.
2. Conversely, a stronger-than-expected U.S. economic growth, as indicated by various GDP Nowcasting models, coupled with the PBOC’s stimulus measures, could reignite inflation. This would undoubtedly complicate the Fed’s path and force them to maintain higher interest rates.

We assess the following scenarios (Mid 2025):

• Scenario 1 (35%): The Fed is somewhat stuck and the policy rate remains above 4%.

• Scenario 2 (40%): All goes according to plan and fed funds fall within the 3-3.75% range.

• Scenario 3 (25%): Unemployment accelerates, leading to a more aggressive rate cut path below 3%.

ATM implied volatility trades below mid-range, while the skew remains elevated compared to the last 2 years’ trading range. Despite a surge from recent lows, the skew remains negative, indicating that puts are still more expensive than calls.

To simplify our discussion, we’ll use 2Y U.S. Treasury futures as an example of how we would structure a trade.

The 2Y Treasury Futures yield (see chart below) is trading near 3.42%, consistent with a rather swift decline of SOFR rates to around 3% by mid-2025.

Proposed Trade:

• Short 2Y Treasury Futures: Establish a short position to benefit from a bounce in 2Y rates. It feels like a must to combine this trade with a Tail Hedge: Protect against a potential increase in unemployment and subsequent aggressive rate cuts by purchasing a call option with a strike price of 2.75%.
• Alternative: 1×2 Call Spread: Consider selling a near-the-money call option and simultaneously buying two out-of-the-money call options. This spread can offer a more defined risk-reward profile. For example, sell a 3.5% call and buy two 3% calls.

Happy trading and see you next week!

InflectionPoint

Disclaimer

All views expressed on this site are my own and do not represent the opinions of any entity with which I have been, am now, or will be affiliated. I assume no responsibility for any errors or omissions in the content of this site and there is no guarantee for completeness or accuracy. The content is food for thought and it is not meant to be a solicitation to trade or invest. Readers should perform their investment analysis and research and/or seek the advice of a licensed professional with direct knowledge of the reader’s specific risk profile characteristics.