More Data Dependent Than Ever – A Look at Dot Plot, Neutral Rate and Fed Funds vs Treasuries
Fed Meeting Aftermath:
Fed policymakers kept options open at last week’s meeting. They left rates unchanged (as expected) and updated the “dot plot” prediction of three rate cuts this year (indicating they are so far undeterred by recent hotter than expected data). Fed Chair Powell was very accommodative in tone, describing the December/January data releases as “seasonal” and not concerning. Today’s February PCE release was slightly cooler than expected with core monthly at 0.3% (0.4% expected) and 2.5% annually. The next few months will have to improve on that to see the expected/hoped for/will it really happen? Rate cut at the mid-June Fed meeting (May is pretty much off the table). Right now, the Fed is hedging both sides: telegraphing 3 cuts for election year “cover” while reminding us that everything is data dependent, and they are willing to go “higher for longer”.
The Dot Plot:
Fed Funds rate is 5.25-5.50% today. Three cuts this year would put it at 4.50-4.75%. The dot plot predicts 3 or 4 rate cuts in 2025, followed by 2 or 3 cuts of 3 rate cuts in 2026. Assuming 9 or 10 total cuts over the next 3 years would put the Fed Funds rate at 2.75-3.25%. Neutral Rate: The “neutral rate” (aka r*) is the equilibrium short term interest rate that would be appropriate for an economy at full employment and stable inflation – meaning the Fed’s famous “dual mandate” is “mission accomplished.” Last week the Fed moved its estimate of the neutral rate to 2.6% (up from 2.5%). Note that the neutral rate was often predicted at 2.4% during the 2010s era of ultra-low Fed Funds rates under 1%. Many analysts believe that the Fed is gradually moving up the estimated neutral rate of 3%.
Fed Funds and Treasuries:
Of course, many real estate investors are focused on treasuries, the benchmark for debt costs on stabilized properties. The question often asked these days is “what will happen with Treasuries when the Fed finally cuts rates?” The typical CRE loan is based on the 10-year Treasury and the Fed Funds rate is short term. The 10-year Treasury yield is heavily influenced by investor expectations on where interest rates will be over the next 10 years. Remember in December when the market was predicting 9 rate cuts (!) in 2024 and the 10-year T dropped to 3.79%? Today the prediction is for 3 cuts and the 10-year Treasury is at 4.20%. When were we last at or near the neutral rate? In Dec 2018, the Fed raised rates to 2.25-2.50%, where it stayed throughout most of 2019, until rate cuts in Aug-Oct (The 10-year Treasury dropped from 3.15% to 2.00% during that period as the economy contracted). Then came the 2020 pandemic, slowdown, stimulus and severe cycle distortion. The chart above shows the spread between the Fed Funds rate (blue) and the 10-year Treasury (gold). Since 1990, the 10-year Treasury typically ranges about 1.50% above the Fed rate. So, a 3.0% neutral rate would indicate a treasury in the 4.50% range. Of course, dot plots are superseded regularly and unless you forgot, everything is data dependent. Stay tuned…