The FED: Sep24 SEP Analysis
Disclaimer: For informational purposes only.
Please see here and here for more information about The Weight of the Evidence.
Updated Write-Up: September 16
Discussion
In last week’s write-up (see below) I clearly didn’t have an appropriate handle on what the SOFR curve implied for FED rate policy over the next two years. Using the more accurate Fed Funds futures data, it’s clear that for rates market pricing for Fed Funds looking out to December 2026 to be realized, labor market data would need to deteriorate meaningfully in the coming months, likely through the initial jobless claims channel.
As I type at 11:37am EST, odds of a 50 bps cut on Wednesday sit at 61%. I have no idea if Powell will go 50, but what I do know with high certainty is that the September SEP is going to be hawkish to wildly hawkish relative to current market pricing. The rates market and financial market participants have routinely under-estimated the FOMC’s H4L resolve, and despite Powell’s “whatever it takes” speech at JHOLE24 I believe this time will not be different given how aggressively the market has front-run the Fed. Perhaps this is why Powell wants the option of going 50, to soften the financial market blow of a hawkish SEP (?).
Analysis
In my base case September SEP construction I have the Fed projecting a 1.2% real Fed Funds rate by December 2025, just .4% above its long-run neutral rate of .8%. Assuming the FOMC pencils in a 2025 exit rate for core PCE of 2.2%, the FOMC is likely to project exiting 2025 with a nominal Fed Funds rate of 3.4%. As of this morning, the Fed Funds futures market has the Fed cutting to 3.1% by June 2025 and closing the year at 2.8%.
A 2.8% Dec25 Fed Funds rate, as implied by Fed Funds futures, (assuming the FOMC pencils in 2.2% core PCE inflation) means the Fed would project cutting to below its own collective estimate of the neutral real rate with core PCE inflation still above target. Likewise, a 3.1% rate by June, .9% above a 2.2% core PCE rate, implies the Fed engaging the “3% neutral by spring” scenario as discussed yesterday.
Even in my estimation of a best case SEP scenario where the Fed cuts to .8% neutral by Dec25 with 2.2% core PCE inflation in place, the Fed Fund futures market is still too dovish.
Original Write-Up: September 11
Discussion
The SOFR curve currently has the Fed cutting by 210 bps by December 2025, a level of cuts regularly viewed by market participants as out of line with reality due to a still-strong economy. But when you run through the Fed’s real Fed Funds framework that has guided their SEP production over the last couple of years, it’s actually pretty fair pricing.
The Fed will say that the SEP is an amalgamation of 19 participants’ projections and not a finely tuned policy guidance tool, but the projected real Fed Funds rate is the key tell that the FOMC is very specific in how it calculates its policy guidance:
September 2023 SEP: Inflation was a concern and the Fed came out with a hawkish set of dots.
2.5% real Fed Funds by December 2024,
1.6% by December 2025, and
.9% by December 2026
December 2023 SEP: The first “Powell Pivot” was in full swing, and the Fed softened its guidance.
2.2% real Fed Funds by December 2024,
1.4% by December 2025, and
.9% by December 2026
Two different inflation circumstances, yet the December 2026 real Fed Funds rate stayed the same at .9%. That tells me the Fed has something very specific in mind when it comes to the SEP as a policy tool.
So, with this real Fed Funds rate framework in mind, let’s look at what the September 2024 SEP is likely to look like.
September 2024 SEP Analysis
Assumptions
First and foremost I assume the Fed projects three cuts at the final three FOMC meetings of 2024, bringing the December 2024 Fed Funds to 4.6%
Given better than expected inflation data, I brought down the projected core PCE inflation rate to 2.7% and 2.2% for 2024 and 2025, down from 2.8% and 2.3% in the June SEP
I assume the Fed will want to keep the unemployment rate in check at around 4.2% in the out years, as projected in the June SEP
In order to keep the UR in check I assume the Fed will want to get to its long run neutral real Fed Funds rate of .8% by December 2026.
Lastly, and most importantly, for the December 2025 real Fed Funds rate I believe the Fed will do something along the following lines:
In the dovish December 2023 SEP the Fed projected a .9% real Fed Funds rate for December 2026
But since December the long run neutral rate has risen from .5% to .8%
I think they’ll adjust that .9% up to 1.2% and pull it forward to December 2025
Discussion
I went through the exercise above to construct the SEP below without looking at SOFR pricing and assumed I would come out to materially fewer implied cuts by December 2025 and 2026. Interestingly, I came out to cumulative cuts of 200 bps by December 2025 versus 210 for SOFR, and 260 cuts by December 2026 versus 210 for SOFR.
My focus is principally on the equity market, but if I was so inclined to trade SOFR I would not bet on the SOFR curve repricing to fewer cuts any time soon. As demonstrated above, the Fed can easily get to 260 bps of cuts by December 2026 while credibly maintaining that it is keeping restrictive monetary policy in place until inflation is back to 2%.
Of course, so much of this is path dependent. If the economy responds to the aggressive easing of policy over the last two months the Fed could easily be back to hiking rates at some point in 2025 and SOFR will reprice aggressively. But now is unlikely the time to make that bet given how risk-off the “guts of the equity market” are at present.
From an equity market perspective, until the economy reaccelerates I believe the Fed needs to project more aggressive cuts than SOFR through 2025. Equities are simply saturated with two years of FED dovishness, and now that the long-awaited cutting cycle is here, there just isn’t enough juice to power this overvalued pig of a market sustainably higher from current levels.