Primary Dealings

Monday 07/14/14

      Last week the Federal Reserve Bank of New York released the results of its June survey of primary dealers. Primary dealers are the counterparties to the New York Fed, which means that they are required to participate consistently in FOMC (Federal Open Market Committee) operations. This means that they buy and sell bonds with the Fed and make a market in U.S. government securities. In addition to trading directly with the Fed, primary dealers are expected to “…provide the New York Fed's trading desk with market information and analysis helpful in the formulation and implementation of monetary policy.” This week I want to look at the results of a survey conducted by the fed and taken by the primary dealers. The responses of the primary dealers are used by the Fed to make future monetary policy decisions.
     The most recent survey was conducted this June, primary dealers were asked several questions about their thoughts on the economy, financial markets and future expectations of the fed. You can read the entire survey here. I am not going to dissect the entirety of the survey, but instead I am going to focus on the following question: “Of the possible outcomes below, provide the percent chance you attach to the 10-year Treasury yield falling in each of the following ranges at the end of 2014 and 2015.” To give you a frame of reference, the average closing price of the ten-year yield was about 2.59% in June. The results of the survey are shown in the figure on the right; keep in mind that this is the average of all the respondents’ answers.
     The responses from the primary dealers show that they expect interest rates to move higher in the coming year and a half. However, they were much more confident that rates were going higher earlier in the year. The next chart on the right shows the results from the same question asked in February and how they have changed. Clearly expectations for higher rates were incorrect and the dealers were forced to revise their answers. This change may have had something to do with the consistent move lower despite the majority of analysts who were claiming that the end of quantitative easing was a virtual guarantee that rates were going higher. What is interesting is that the calls for higher interest rates ignore historical evidence that seemingly points to the exact opposite outcome. For more on the counterintuitive movement of the 10-year read this.
     I also want to look a little more closely at this question to see if it is leading the primary dealers to a particular outcome. The last picture on the right shows the blank question that was sent out to the primary dealers. The two extremes of the 2014 choices are ≤2.00% and >4.50%. The 10-year was between 2.58% and 2.65% which means that 2.00% was only between 58 to 65 basis points away, but 4.50% was 174 to 185 basis points away, not to mention that a move in this direction would buck a thirty-year downtrend in the ten-year yield. Furthermore, that level has not been seen in the last five years however the ten-year yield was below 2% less than two years ago. Interest rates at the time of the question were closest to 2.50% so why wouldn’t one of those options represent the center of the choices. Instead those choices are pushed to the left, and what is even stranger is that the 2015 choices show ≤2.50% as the furthest left choice with no levels of precision below 2.50% offered, even though 2.50% was only 8 to 15 basis points away at the time. A move of 8 to 15 basis points could easily happen in one day.
     So why am I drilling down on what may very likely be minor error on a fairly inconsequential survey? I think that this question reveals a bias on the part of the Fed for higher interest rates. The Fed has expressed concern over a reach for yield and the exuberance in particular areas of the economy. It is possible that the fed is trying to use the primary dealers to raise interest rates and cool some of this perceived speculation. Of course, it is entirely possible that this was just an old question that was copied and pasted by an intern at the Fed and there is no meaning behind it whatsoever, but regardless it could be having an impact on the primary dealers. The responses of the primary dealers will almost always form a nice neat bell curve, but that bell curve will likely be shifted to the right depending on the choices given. Furthermore, these responses and the question in general show a complete lack of understanding of tail events and their likelihood of occurring.