Reading the Fed Tea Leaves

HFA Partners  |  September 26, 2016

The Fed held rates unchanged at last week's FOMC meeting, noting economic growth was not quite there yet, but left the door open to a hike later this year. Fed watchers are debating what to expect for the next three months and for 2017, and predictive tools diverge on what the Fed will do.

Last year, we boldly predicted to Modern Healthcare that a Fed rate hike wouldn't deter healthcare borrowing.

When the Fed did raise the target rate last December, the first hike since 2006, short-term rates went up but long-term rates dropped.

The bond markets have since experienced close to a full year's worth of consecutive municipal fund net inflows, the 30-year MMD "AAA" tax-exempt yield lost 60 basis points, and a slew of hospitals have taken the opportunity to sell bonds.

The drop in rates on the long end of the yield curve has meant more advance refundings came in the money, some in spite of long escrow periods with lots of negative arbitrage.

The issuance spike has been more noticeable among higher-rated hospitals in the A and AA categories:

hospital-issuance-volume-since-december-2015-rate-hike

So will the Fed hike rates again this December?

Hospitals considering going to the bond markets and looking for an answer have a couple of tools available to weigh the odds.

The first predictive tool is based on Fed funds futures.

Fed funds futures allow banks and various institutional investors to hedge against unexpected changes in short-term rates. Pricing for these contracts vary by month and is based on 100 minus the expected Fed funds rate. If the price of a particular month's contract is 99, then traders expect the average federal funds effective rate during that month to be 1% (100 - 99). So by comparing Fed funds futures contracts for different months, once can determine how the market expects the Fed funds rate to change over time.

The CME Group reports that according to its FedWatch tool, futures predict a 54% probability the Fed funds rate will be raised to a range of 0.50%-0.75% or more following the FOMC December 2016 meeting. The target rate is currently set at a range of 0.25%-0.50%.

probability-of-target-rate-following-dec-2016-fomc-meeting


Unfortunately, Fed funds futures aren't particularly accurate. Last October, CME Group reported a 64% chance of no rate hike at the December 2015. That proved to be wrong.

The second predictive tool is based on the so-called "dot plot" which reflects FOMC member expectations over time.

The Fed publishes these expectations every three months and the September dot plot shows a majority of FOMC members favor a rate hike between now and the end of the year. The dot plot suggests a Fed funds rate mid-point between 1% and 2% in 2017, significantly higher than what futures predict:

fed-dot-plot-sep-2016
Source: Federal Reserve Monetary Policy – FOMC Calendars.

Only three "no hike" dots remain for 2016.

But the dot plot isn't too accurate either, primarily because it reflects what each FOMC member thinks the Fed should do, not what they expect it to do, and that not all dots carry equal weight. The September 2015 dot plot showed the majority of FOMC members wanted the rate in the 1 to 2% range in 2016. Unless the rate is raised twice between now and the end of the year, that's not just going to happen.

Assuming a Fed rate hike, the bigger question is how will it impact the long end of the yield curve.

So there is still no reliable way for hospitals and other borrowers to predict interest rates.


This material is intended for general information purposes only and does not constitute legal advice. For legal issues, readers should consult legal counsel. To discuss this article or municipal advisory services, email info@hfapartners.com or call 888-699-4830. HFA Partners, LLC is an Independent Registered Municipal Advisor registered with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) under the Dodd-Frank Act of 2010.
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