Will The New Year Be Another "Groundhog Day" For The Fed?

In the 1993 movie Groundhog Day, Bill Murray plays an arrogant weatherman who gets stuck in a "time loop" and is forced to relive the same day over and over again. Lately, the Federal Reserve has seemed a bit like Bill Murray on a slightly longer timeframe. Tell me if this sounds familiar:

After a disappointingly dovish year when the Fed was forced to keep interest rates unchanged longer than it had hoped, the US central bank was finally able to raise the Fed Funds rate in December and set out an aggressive path of interest rate hikes for the coming year.

While this description obviously describes 2016 to a "T", it's also a perfect recap of 2015 (and excluding the December rate hike, aptly summarizes 2014 as well). So as we head into another year of optimism for US economic growth, thrice-burned investors are wondering: Will this be yet another "Groundhog Year" for the Fed, or has the US economy finally escaped its time loop?

It's said that the three most dangerous words in investing are, "it's different this time." But based on the intermarket price action, there's certainly some evidence that 2017 could be different. As the ball dropped on 2014, 2015 and 2016, there was a clear divergence between what the Fed expected for interest rates (multiple increases in the coming year) and what traders were pricing in (a maximum of one rate hike).

While we hesitate to say that traders are "drinking the Fed's koolaid" this year, Fed Funds futures traders are pricing in between two and three rate hikes in the coming year, with nearly 40% of traders expecting at least three rate hikes , according to the CME's FedWatch tool.

This optimism is also reflected in the 2-10 yield curve (that is, the difference in interest rates between the 10-year Treasury bond and the 2-year note). As the chart below shows, this measure has finally broken above its multi-year downtrend.

Source: Fred

Because Fed policy heavily influences the short end of the curve and expectations about future economic growth and inflation drive the long end, this breakout shows that investors may finally be shaking off their multi-year malaise about the long-term prospects for the US economy. Before investors blow their party horns though, we wanted to point out that the yield curve saw a similar 60bps rally back in H1 2015 before rates rolled over and extended their downward trajectory. Readers will want to see the yield curve to hold steady, or ideally continue to steepen, through the first half of 2016 to have more confidence in the Fed's hawkish tendencies.

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It's also worth noting that the Fed has been extremely hesitant to "surprise" the market, so if the central bank continues to follow its established modus operandi, it will need markets to remain supportive when a rate hike is more imminent, potentially around the March or June meeting. Will 2017 finally be the year that the Fed is able to "normalize" policy more aggressively or will we see another "tightening tantrum" from the markets that causes the central bank to hold fire once again? Only time will tell.

For those who haven't seen the movie, Bill Murray's character is finally able to break the loop by practicing selfless empathy and helping the people around him with their daily trials. Regardless of what the Fed does in 2017, Groundhog Day still offers a great allegory for how we should strive to live our lives next year and moving forward.

Here's to a healthy, profitable, and happy New Year from the team at Faraday Research.

Written By: Faraday Research