UBS: Follow the lender

Does the Fed lead the market, or does the market lead the Fed? Who is in charge? The old adage may say never fight the Fed, but the Fed's critics would suggest it may be more a case of the Fed not wishing to fight the market. The Fed would disagree; after all they are both looking at the same data. But neither the Fed nor the market have been that good at forecasting the data in any case.

22.03.2016 | 13:04 Uhr

Don't fight the Fed. That has been the advice of fixed income traders for decades. Traders who try to take the opposite trade to the direction the Fed is moving tend to lose their shirt. It is hard to fight against the lender of last resort that has a (theoretically) unlimited balance sheet. That makes sense for individual traders. But what about the reverse: should the Fed fight the market?

When the market suddenly turns more dovish on the outlook (or rarely, more hawkish), should the Fed ignore that move? In some cases the Fed may well follow the market, simply because the market reacts to the new data day-by-day whereas the Fed reacts to the same data only once a quarter. On other occasions the Fed might want to ignore the data that excites the market and instead focus on the longer term. After all, isn't a central bank meant to have a longer time horizon than the market?

The Fed is sometimes criticised for being afraid of upsetting the market, for being a follower rather than a leader. But how often does the Fed move the way the market does? In recent years the Fed has only changed its interest rate once, but thanks to the publication of its forecasts we can see clearly how FOMC members' expectation for the Fed Funds rate has changed every three months. If the change in the estimate between projections is similar to the change in market pricing, then the Fed is arguably a follower rather than a leader.

The evidence is mixed at best. Sometimes the Fed does follow the market moves, most clearly in December 2013 and December 2014 when it turned more dovish (chart 1). In September last year the Fed also turned more dovish (at the same time that it delayed a rate hike that was widely expected by economists, if not by the market). In contrast, there have been several occasions when the Fed led or was independent of the market, coming out either more hawkish or more dovish than expected.

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