Investors should be worried more about whether the hawks will take over the Federal Reserve, because of the impact that voting at the Fed's Open Market Committee will have on stocks and bonds.
If the Fed hikes short-term interest rates quickly, that could blunt stock returns and hurt short-term bonds, while inaction on rates could hurt long-term bond investors, as inflation expectations ratchet up. Oxriver Capital's analysis of the Fed's voting coalitions indicate that interest rates should hit 1.125% by the end of 2015.
The Fed's biggest dove and hawk, respectively, Narayana Kocherlakota of the Minneapolis Fed (top) and Charles Plosser of the Philadelphia Fed (bottom), don't vote on interest rates in 2015. The pictures are from the Federal Reserve.
When it comes to economic policy, Congress has long ceded its role to the Federal Reserve. The Fed votes and acts on important economic policy matters every six weeks.
The "parties" that matter on the Fed are not Republicans and Democrats, but rather hawks and doves. The Fed hawks favor higher interest rates because they want to stop inflation from getting too high. The doves are less worried about inflation they want lower interest rates to stimulate the economy and job creation.
Oxriver Capital has come out with its first Dove vs. Hawk ranking below. FOMC voters in 2014, 2015 and 2016 are highlighted.
Figure 1: Oxriver Capital, November 2014, Dove and Hawk Ranking
There are 17 Board of Governors members and Federal Reserve Bank presidents who at some time get to vote on interest rates. The most dovish potential voters get rankings closer to 1.
Narayana Kocherlakota of the Minneapolis Fed, the biggest dove with a ranking of 1, dissented for the first time last Thursday. That FOMC statement was much more upbeat about the labor market progress and said the Fed would end its third bond-buying program, known as quantitative easing.
In addition, it saw two of the biggest hawks -- Charles Plosser of Philadelphia, ranked 17, and Richard Fisher, ranked 15 -- vote with the majority on the FOMC. Most regional bank presidents get to vote on interest rates only in one year out of three. Thus, Fisher, Kocherlakota and Plosser won't vote next year.
Investors care about the shifting voting coalitions at the Fed because the voters determine interest rates. The median voter in any election typically sets policy. If the median voter favors the higher interest-rate alternative, the hawks will win. If the median voter favors the lower interest-rate alternative, then the doves will win.
The victory for the Fed hawks last week may be short-lived. In 2015, the median voter becomes more dovish than in 2014. Yet, a GOP-controlled Senate may put more pressure on the Fed to hike rates.
Figure 2: The FOMC's Median Voter's Dove v. Hawk Rank Over Time
Based on the Dove vs. Hawk ranking and the Fed's interest-rate projections, the dot plot, Oxriver Capital believes the Fed will raise interest rates to 1.125% by Dec. 31, 2015.
Figure 3: Oxriver Capital's Estimates of the Interest Rate Projections for Each Rotating Voter on the FOMC
Based on the voting coalitions on the FOMC and the dot plot, the most likely path of interest rates in 2015 are plotted below. A large number of Fed voters have pointed to mid-2014 or earlier for the first Fed rate hike.
Figure 4: Projections of Interest Rate Hikes in 2015
Yet, the Fed funds futures market is betting against the Fed's projections in the dotplot and Oxriver Capital's projections in Figure 3. On Oct. 31, the futures markets were betting that overnight rates would hit only 0.63%. That is lower than the median of the most dovish 10 dots of the FOMC's projections.
Thus, the futures markets are more dovish than the most dovish possible FOMC coalition. Yet the futures markets are more hawkish than the number 1 dove on the FOMC, Kocherlakota, who likely doesn't want any rate increases in 2015.
That the bond and futures markets are fighting the Fed makes the case for shorting the two-year Treasury note and shorting the January 2016 Fed funds futures contract.
The height of the stock-market correction and bond-market rally last month occurred on Oct. 15. Since then, traders have been expecting more interest-rate hikes.
Figure 5: Interest Forecasts of FOMC voting coalitions and Fed Fund Futures
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.