Fed will be up on its tiptoes for some time to come

One week to go before lift-off and 10Y Treasury yields are still at 2.21%. That's 20 basis points higher than in mid-October but one certainly would have expected a bigger move given the dramatic shift in Fed expectations between now and then. Back in mid-October, markets reckoned the odds of a December lift-off were less than 1:3. Three weeks later, the odds had completely pivoted to 3:1 in favour. Today, they are 4:1 (79%) in favour. The economy hasn't changed - 4Q GDP growth stands at 2.1% in both sequential and on-year terms. Nonfarm payrolls are smack on their 210k / month average of the past four years. And core PCE inflation - the Fed's favoured gauge - remains at 1.25 YoY, where it's been for the past 4 months. What gives? Why do markets all of a sudden think lift-off next week is a done deal and yet think 10Y Treasury yields should remain at 2.20%? 

Markets think lift-off next week is a done deal because Fed officials have all but said so. No more no less. One has to respect that. The question then becomes: what pace? A 10T Treasury yield at 2.20% says markets think the Fed will hike slowly. And indeed the Fed says it intends to do just that. But the 2 hikes that markets price in 2016 (after the first in December) - and which are embedded in the Treasury curve - seem a bit too slow. 

Why? The raison d'etre of proceeding slowly is to keep markets calm and cool. But the Fed has to move at a deliberate and observable pace too, otherwise it throws all that hard-earned stability right back out the window. Hiking next week and then waiting until June - the mid-point of 2016 - to hike again would only make markets anxious and grumpy. Hiking once every 6 months isn't a deliberate or 'observable' pace - it's a 'what the heck are they doing?' pace. The only strategy that seems to be both slow and deliberate is to hike on an every-other-meeting basis. That's half the 'normal' Fed pace - calm - but it's clear and steady too. 

If the economy slows, then of course 2 hikes in 2016 is a possibility. This is the risk the Fed takes. If you want to normalize slowly, you have to begin before you otherwise would - before you know it's really time. There's no way around this. All you can do is put a hike out there and see what happens. Put another one out there, check again. If all goes well, by this time next year, the economy is expected to survived and the Fed likely delivered 5 hikes in total. 

What are the risks? The things to watch? That's easy - housing, investment and exports, the most interest rate / FX-sensitive sectors of the economy. None are doing well. All are vulnerable, though to what degree is an open question. The Fed will be up on its tiptoes for some time to come.