MARKET ANALYSIS: April 2015

Disconnect Between the Fed and the Market
You might be asking yourself some questions like: Why should we even care about which month the Fed starts moving interest rates higher? What is the big deal if it is July or September? As it turns out, it could be very important. There is a very big difference between what the Fed says it is going to do and what the current market interest rates believe the Fed is going to do. The timing could be important in building credibility in the financial markets that the Fed is planning and willing to boost interest rates significantly over the next few years.

Because the Fed kept pushing off any change in interest rates, markets still do not really believe the Fed is serious about boosting interest rates significantly over the next three years.

The median forecast of FOMC members puts Fed Funds at 1% by the end of this year, 2.5% by the end of 2016 and at 3.8% by the end of 2017. The Fed Funds Futures market trading has a very different view—only 0.5% by the end of the year and below 2% by the end of 2017.

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This is a very large gap and has a significant implication for bond prices, mortgage rates, stock market values, and exchange rates over the next year. The move up in short-term rate will also translate into significant increases in a 10-year treasury yield and mortgage rates.

Bottom Line: Rate Hikes Will Begin this Year—the Month in Which it Happens is Important
If the Fed pushes Fed Funds rates to 3.8% by the end of 2017, then the 10-year Treasury would likely be near 5% or higher. If so, mortgage rates would push above 6% versus 4% today (similar to where rates were in 2005).

As we gain more conviction about the interest rate trajectory, we will update our view of single-family housing starts beyond 2016 accordingly. If Fed Funds push up to 3.5% by mid-2017, then single family housing starts are likely to peak that year and lose momentum in 2018.

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