Why Is the Market Not Believing the Fed?
Riccardo Rebonato, Professor of Finance, EDHEC-Risk Institute, EDHEC Business School
Riccardo Rebonato, Professor of Finance, EDHEC-Risk Institute, EDHEC Business School is specialist in interest rate risk modelling with applications to bond portfolio management and fixed-income derivatives pricing, He gives us his insights on the release of the latest blue dots.
The latest (March) projections by the Fed Monetary Committee for the Fed Funds in the year to come (the ‘blue dots’) have come out significantly lower than the December projections. In particular, no more rate cuts are expected between now and the end of the year. Yet, even these much lower rates do not seem to be low enough for the market, that seems to be pricing in a substantial probability of a rate cut by year-end. What is going on?
There are a few possible explanations:
Which one is true? Nobody knows, of course. In order of decreasing importance, I would rank explanations 3, 1, 2 and 4. Be as it may, the most striking observation is how much the expected path of the Fed Funds has flattened in the last few years – see the chart below; if anything the market yield curve even shows a small inversion. And a flat or inverted yield curve has traditionally been associated with low or negative risk premia, with challenging times for bond investors, and for sluggish economic growth.
Riccardo Rebonato is Professor of Finance at EDHEC Business School. He was previously Global Head of Rates and FX Research at PIMCO. He also served as Head of Front Office Risk Management and Head of Clients Analytics, Global Head of Market Risk and Global Head of Quantitative Research at Royal Bank of Scotland (RBS). Prior joining RBS, he was Head of Complex IR Derivatives Trading and Head of Head of Derivatives Research at Barclays Capital. Riccardo Rebonato has served on the Board of ISDA (2002-2011), and has been on the Board of GARP since 2001. He was a visiting lecturer in Mathematical Finance at Oxford University (2001-2015). He is the author of several books, in particular having published extensively on interest rate modelling, risk management, and most notably books on SABR/LIBOR Market Model pricing of interest rate derivatives, as well as on the use of Bayesian nets for stress testing and asset allocation. He has published articles in international academic journals such as Quantitative Finance, the Journal of Derivatives and the Journal of Investment Management, and has made frequent presentations at academic and practitioner conferences. He holds a doctorate in Nuclear Engineering (Universita' di Milano) and a PhD in Science of Materials (Condensed Matter Physics, Stony Brook University, NY).