Futures traders are stepping up the pressure on the Fed to ease the pace of interest rate increases.
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Amid the latest round of market turmoil this week, the market has lowered the probability of an interest rate hike when the central bank’s policymaking body meets later this month. They’ve also reduced the chances of future increases, figuring that even if the Federal Open Market Committee approves another quarter-point move higher at the Dec. 18-19 meeting, there only will be one more before it stops.
“How the FOMC chooses to react will greatly determine whether the expansion continues or rolls into recession,” Steven Blitz, chief U.S. economist at TS Lombard, said in a note. “The choice will be to pause: there is no inflation surge to chase down and there are headwinds aplenty.”
The Fed currently holds its benchmark funds rate, which banks charge each other for short-term lending, at a target between 2 percent and 2.25 percent.
Futures markets Thursday pointed to a 68 percent probability of an increase before 2018 ends. That’s still high, but it’s the lowest chance since late-August when the stock market was experiencing some minor choppiness. The likelihood also dipped to around 69 percent in mid-November as Fed officials were busy walking back some of the hawkish talk from central bank Chairman Jerome Powell in early October.
The latest adjustment has come as the market worries over the prospects of economic growth after a robust year. Movement in the bond market is pointing to some worries ahead, as shorter-dated yields are marginally ahead of longer-dated counterparts, often a sign of a slowdown ahead.
Markets are thus expecting the Fed to alter its projections for three rate hikes in 2019 and another one or two in 2020. In fact, there’s nearly a 50-50 chance indicated that by December 2019, the Fed will take back one of its increases and end up in the same range as the end of 2018.
“The Fed will stop hiking and will lower forward guidance, but, given the level of rates, the transition period that has begun will continue both in the US and elsewhere in the world,” Blitz said. “Markets will consequently stabilize but remain volatile while traditional economic guideposts will prove less valuable. Risks abound.”
While pricing in the strong chance of a December hike, implied pricing in the market shows that a funds rate of just 2.6 percent by the time 2020 rolls around. That translates to a target range of, at most, 2.5 percent to 2.75 percent, or one more from the 2.25 percent to 2.5 percent range that a December move would bring.
Part of the reason why Wall Street thinks the Fed will listen is the lack of inflation pressure despite an unemployment rate near a 50-year low.
“The Fed is increasing interest rates so that it has room to lower rates during the next crisis,” wrote Victor Adint, wealth advisor at Raymond James. “It is also increasing rates to get ahead of possible recession. Because of this, it might be less likely that the Fed will go too far, that they might be more careful because they are not presently in a race against inflation.”
Indeed, one of the principal market worries is that the Fed is overestimating the economy’s growth rate and underestimating how close it is too a “neutral” rate that is neither stimulative nor repressive for growth.
“Not since Paul Volcker has the Fed known it was too tight when it was too tight,” Barry Bannister, head of equity strategy at Stifel Nicolaus, said earlier this week. Volcker served as Fed chairman from 1979-87 and shepherded a series of aggressive rate hikes aimed at squelching inflation.
The Fed increasingly appears to be paying attention to market signals.
Powell said in a speech last week that the Fed is getting closer to the range of “neutral” forecasts among FOMC members.
And Dallas Fed President Robert Kaplan said CNBC in a Thursday interview that he believes the current rate is just “a little below” neutral, and said he will have “a strong point of view” at the FOMC meeting this month.
“I’m very attuned to the possibility if not the probability that the economy is going to look very difficult in the first half of 2019 than it does today, because fiscal stimulus is waning,” Kaplan said on “Squawk Box.” “We ought to shorten up our assessment and be willing to be very patient.”