When it makes sense (not) to “fight the Fed”

One of the intriguing features of the human mind is the tendency “to find meaningful patterns in both meaningful [data] and meaningless noise.”^[1] Take our Chart of the Week, which contains both some of the most meaningful and meaningless information on how 2023 is likely to unfold. The spiky line shows market expectations on where the federal funds rate would be at the end of last year^[2]. The stepped line contrasts this with what officials at the U.S. Federal Reserve (Fed) themselves have been anticipating, according to the median of their so-called dot plots^[3].

Intriguingly, throughout much of 2022, futures markets seem to have done a better job than Fed officials themselves on where monetary policy would end last year. Which is interesting, if quite tricky to interpret, not least as FOMC members can update their dots only every three months or so, while market expectations change daily. An additional element of indeterminacy is that while markets watch the Fed, Fed officials obviously also watch fed funds futures. Publishing dot plots arguably reinforced such feedback loops since 2012, potentially making both sets of forecasts less reliable in the process.

Many market participants, though, seem to have gone for a much simpler explanation and appear increasingly self-confident that they can outguess the Fed again in 2023. Futures markets currently price in only 4,42%, for the December 2023 contract. By contrast, Fed officials have been at pains to hint at the prospects of the federal funds rates rising above 5%.

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Compared to Fed officials, market participants proved unusually prescient in predicting U.S. interest rates throughout 2022

* for December 2022

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 1/16/23

For what it is worth, our own views are closer to the Fed’s. As Christian Scherrmann, U.S. economist at DWS points out, a strong labor market could even prompt the Fed to keep rates higher for longer. Beyond that, last year was rather unusual in market participants proving comparatively prescient. As countless empirical studies have shown over the years, futures markets have generally not been all that good at predicting Fed decisions, particularly those almost a year away, as opposed to a few weeks or months. “Also, errors tend to be relatively large when the funds rate changes direction or when it changes rapidly over a short period.”, as one early study, incidentally by a Fed economist puts it^[4].

Or, as the old Wall Street adage has it, “Don't fight the Fed”. Like other mental rules of thumb – what we might call superstitions in other walks of life – that mantra has historically been correct sufficiently often to become conventional wisdom. After all, sudden monetary policy changes usually reflect new information that is, in general, at least as likely to catch markets by surprise as it is to wrong-foot monetary policymakers.

Occasionally, though, such mantras turn out to be wrong. That is when caution becomes particularly important. It is human nature to overestimate one’s judgment and underestimate randomness, especially when one has just had the good fortune to have been proven right. At least from the perspective of behavioral finance, the current self-confidence of many market participants may primarily reflect such recency bias. For that reason alone, the current collective wisdom looks unlikely to prove particularly well-grounded.