Please Stop the Debate Over the Fed’s Credibility


The Federal Reserve remains committed to their AIT framework and employment mandate. Official communications strongly suggest even mildly hawkish rhetoric will not arrive until December 2021 at the earliest.

The debate over whether the Federal Reserve maintains or is losing credibility has become too much! Official communications remain extremely clear dovish policy will persist until the gaping whole put into the labor market is reduced and inflation runs above target for a period of time (i.e. F-AIT).

Most of the excitement within the U.S. Treasury market is found looking more than two years ahead into 2023 and later. Volatility expectations as defined by swaptions eclipsed pre-pandemic heights for only expiries more than two years. Shorter expiries looking into 2021 and 2022 bounced, but remain well-below pre-pandemic levels.

Ultimately, the direction of so-called central bank shadow rates will be steering the vast majority of financial markets. Shadow rates incorporate bond purchases (i.e. quantitative easing) into the official target rates.

We use our natural language processing of ECB and Federal Reserve communications to forecast the path of shadow rates. For each central bank 14 indices are produced ranging from the degree of agreement among officials to political-focused utterances. Ridge regressions are trained on data since 2005 to produce forecasts for the year ahead, which are shown below in the gray shaded area.

All in all, communications suggest the convergence between ECB and Federal Reserve shadow rates will come to an abrupt end by December 2021. Forecasts show the Federal Reserve tapering purchases at the very least, causing the shadow rate to rise over 100 bps into early 2022. 

The U.S. dollar has been particularly attached to this shadow rate differential. We have been unsurprised the U.S. Dollar Index (DXY) has found support near 90.

We have revived our fair value modeling using the following predictors:

    • Economic data changes (G10 economies)
    • Economic data surprises (APAC, LTAM, Eurozone, and U.S.)
    • Global search activity (real-time measures of consumer intentions)
    • Liquidity
    • Leverage
    • Rate hike timing (ECB and Federal Reserve)

U.S. 10-year note yields are currently racing higher away from fair value currently set at 1.19%.

The next chart shows the contributions of each variable to the estimate of the three-month change in U.S. 10-year yields. The swift rebound in retail spending as evidenced by search activity, followed by economic data surprises got the rise in yields underway. However rising expectation of Federal Reserve tightening since mid-February has fueled nearly 30 basis points over the rise in yields since the beginning of December. Investors may be getting ahead of themselves.

Again, the expected path of the Federal Reserve shadow rate is very likely at the helm of interest rates. 


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