Expect A More Hawkish Fed

Ahead of this week’s Federal Reserve meeting and Chair Powell’s press conference on Wednesday, we want to update you on the latest moves in the Fed Funds Futures market. An easy point to start us off: expect a 25 basis point bump to 2.00% - 2.25%. Futures markets give that outcome a 92% chance.

But here’s something to chew over with your colleagues: the odds of the Fed going 50 bp on Wednesday has gone from stone-cold zero to 8% in the last month. That’s just slightly less than the chances you’ll flip a coin 4 times and have it come up heads each turn (6.3%). And while the Fed hasn’t moved at a non-press conference meeting since they started these scheduled chats, futures give a slightly better chance (10.2%) of either 50bp this Wednesday or another 25 bp at the November 8th meeting.

That said, Fed Funds Futures do still show a high degree of certainty that rates will end the year 50bp higher than now (at 2.25% - 2.50%), with 75.8% odds. As with the September/November contracts, however, the bias over the last 30 days has been to pricing in faster tightening. The odds of rates ending the year higher than 2.50% have risen from 1.6% to 8.7% over the last month.

Now, since much of the buzz around Wednesday’s meeting will revolve around the Fed’s “Dot Plot” of expected future rate policy, here is what to know on that score:

• Back in June, the Fed’s Summary of Economic Projections showed a mean expected Fed Funds rate of 3.1% at the end of 2019.

• The Dot Plot of individual policymakers’ expectations clustered at either 2.75% - 3.00% (4 dots) or 3.00% - 3.25% (4 dots). The next most popular choice was 3.25% - 3.50% (3 dots).

• Fed Funds Futures currently price in a December 2019 rate of 2.82%, inline with the lowest cluster of Fed Dots, and implying 2 rate increases next year (at 25 bp apiece).

• 2-year Treasuries, the most sensitive part of the yield curve to Fed policy, currently pay 2.80%. This fits with December 2020 Fed Funds Futures, which currently price in a 2.87% rate.

The bottom line to all this in terms of anticipating the tone of Wednesday’s meeting:

#1. Recent price action in both the Futures and 2-Year Treasury markets imply the Fed/Chair Powell will sound more hawkish at this meeting. The former has recently started discounting some modest chance of a 50bp move, which would be a real surprise. The latter saw a new post-crisis high for yields on Thursday at 2.81%.

#2. While Futures markets now discount the Fed reaching the lower end of its “Dot cluster” for next year, they are not yet on board with the 3.1% mean expectation published in June. Given the ongoing strength of the US economy (especially recent wage gains) since then, we expect to see the 2019 Dot Plot and mean rate expectation move higher.

To the degree to which capital markets use Fed Funds Futures as a “base case”, that may be an unpleasant surprise. If this reignites a dollar rally, look for renewed weakness in Emerging Markets.

#3. We also expect the 2:00pm press conference to be dominated by questions about trade policy even though Chair Powell has studiously avoided this political third rail in the past. Will tariffs cause inflation, mandating the need for more rate hikes? Or will they cool spending and capital investment, moderating the need for higher interest rates? Or both?

The answer is simply “No one knows yet”, but injecting an existential unknowable into the market’s perspective on interest rates is an unwelcomed problem.

Summing up: look for a more hawkish near term tone out of the Wednesday Fed meeting, something the Futures/Treasury markets are telling us to expect. Just as important, however, will be how Chair Powell navigates the tariff issue given recent headlines.

See the Fed Funds Futures odds here, updated in real time: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html