The Market Is Wrong.

The inevitable outcome to someone who utters the above words is usually a healthy serving of shoe. In other words, when people are so bold as to make statements questioning the rationality of the market, the market usually ends up making a fool out of them.  As investors, we are instructed that because no individual is smarter than the market, we should always defer to what the market is telling us.  But should we?

Earlier today, we showed a chart showing that the expectations of a Fed rate cut anytime in the next six months are under 40%.  Most people would look at that and say it is more likely than not that the Fed is not cutting rates. However, if we look back over history to see how accurate the market is as a predictor of the Fed's action, we find that most of the time it is usually off the mark.  Since 1998, the average margin of error is actually about 45 basis points.

The chart below shows the spread between the implied Fed Funds rate six months out and the actual Fed Funds rate six months from a given day.  Since 1998, the market has had some periods where it was widely off the mark. Consider late November 2000. At the time, the market was expecting the Fed Funds rate to be around 6.25% come late May of 2001. The actual Fed Funds rate in late May was 4%. Granted this is an extreme example, but it illustrates the point.

The market's recent preoccupation with Fed rate cuts is not anything new.  For nearly three years now, the market has been overly optimistic of its outlook regarding Fed policy, whether it was the pre-mature prediction of a pause or the recent prediction for cuts to begin. Currently, the market has priced in a Fed on hold.  Given the track record, this makes one want to bet on a change.

Comments

[MARK T]

The market is not predicting the change in fed rates, it simply reflects the cost of hedging against the possibility; as such it reflects the risk tolerance of the partcipants far more than any "prediction" of the direction of interest rates. In effect this is the same as the way the price of, say, hurricane insurance does not always reflect changes in the probability of hurricanes.