The December ‘dot plot’: even lower future yields than meets the eye

The December ‘dot plot’: even lower future yields than meets the eye

Riccardo Rebonato, Professor of Finance, EDHEC-Risk Institute

Many commentators have pointed out how much lower the dots on the Fed plots have moved from September to December. They may actually imply significantly lower yields than generally recognized. Why so?

The question the members of the FOMC actually answer is about the most likely realization of the Fed funds at different horizons. Now, an answer of, say, 3.00% to this question means that, in the estimate of the member, this is the most likely future value, but it does not mean at all that deviations from this most likely value are symmetrically disposed.

In the present conditions this matters a lot: with an expansion that is now very long in the tooth, and a wobbly S&P, there is much greater scope for downward than upward surprises in rates. Prices (and therefore yields) take all outcomes into account, not just the median of the distribution, and therefore a reading of the dot plot attuned to the current market conditions would suggest even lower yields than what the blue dots at first blush seem to imply: the Fed is telling us “this is the most likely event”, but is also telling us “If there are surprises, expect more bad than good ones”.

Indeed, the inversion in the belly of the curve implied by the blue dots clearly shows that the Fed expects to be called into action in the short-to-medium term – hopefully for nothing more serious than an organic cooling of the economy. The closer the inversion moves to the short end the yield curve, the most “clear and present” the danger of a recession becomes: so the positioning of the inversion point is a quantity to watch carefully in the releases to come.

Beyond the short and medium term, the most noteworthy feature is the extremely low level of the ‘last blue dot’ - the dot that should reflect the long-term expectations of the Fed funds: to put things in perspective, the last blue dot has declined from over 4.00% in January 2012, to 3.75% in December 2014 and to below 3.00% in December 2018. If the ‘natural’ level of rates is an indication of long-term expectations about economic growth, the Fed is indicating that we may be entering a period of secularly lower 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).