Fed Funds Futures Just Won’t Quit Worrying

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Fed Funds Futures Just Won’t Quit Worrying

Published 3/22/21

Three Data items today:

#1: Fed Funds Futures are now pricing in higher probabilities of a rate increase this year. The graph below comes courtesy of the CME FedWatch tool. It shows that, despite Chair Powell’s very clear communication at last week’s press conference, markets aren’t entirely buying what he’s selling.

One week ago, the odds of a Fed rate increase this year were 2.1 percent; now they are 11.7 percent. This isn’t the world’s most liquid market, to be sure. But we’ve promised to stay on top of this indicator and today’s prices are certainly worth a mention.

Takeaway: Fed Funds Futures have been a far better predictor of future Fed action than virtually all human economists, so as crazy as this market’s signal may seem we won’t just wave it off. The only reason to question the marginally higher odds we’re showing you today is that 2-year Treasury yields have not really budged. They are lingering right in the middle of their recent band at 0.15 percent. The level to watch is 0.19 percent, mid-November 2020’s high point. If they go higher than that, then a very liquid market will be confirming what Fed Fund Futures are already starting to signal.

#2: We’ve recently discussed with you how the inflation expectations built into TIPS prices have been ramping quickly; here is a chart that shows 5-year TIPS expected inflation (blue line) and Fed Funds rates (red line) back to 2005.

We’re not sure if Chair Powell has this chart taped to the monitors in his office, but it certainly reflects his perspective on what’s been wrong with Fed policy for many years. Look at how high Fed Funds were pre-Financial Crisis (red line over 5 percent) even though inflation expectations were in a gently sloping band moving downward from 3 to 2 percent. Higher rates were not the antidote for the housing bubble – that needed regulation, which of course came only after the Financial Crisis. Later on, the Fed (under his watch, admittedly) raised rates just as inflation expectations were coming down (the right side of the chart, pre-Pandemic Recession). At least he owned up to his mistake in January 2019…

Takeaway: Chair Powell, and we assume his Democratic successor, is leaning very hard on the data in this chart when they promise no rate increases for a long time to come and only when actual inflation is running hot. Today’s TIPs-implied future inflation rate is simply back to a long run norm, not through to new highs. The Fed will not be baited into over-reacting, regardless of what Fed Funds Futures (Point 1) may say.

#3: We’ve mentioned in past reports how non-Tech stocks outperformed from the peak of the dot com bubble on March 10th, 2000 through the end of the year, but today we want to show you the actual numbers. This experience taught us that capital flows somewhere, even when a market leadership group starts to stumble.

These are the returns for 4 non-tech large cap sectors from March 10th through December 31st, 2000, when the S&P 500 was down 5.8 percent on a price basis:

  • Financials: +47 percent
  • Energy: +20 percent
  • Industrials: +19 percent
  • Consumer Discretionary: +3 percent

Importantly, the Fed did not start cutting interest rates until 2001. These moves were not due to a change in monetary policy. On top of that, the moves in Financials, Energy and Industrials from March – December 2000 were slow and steady. It took many months for capital to cycle out of Tech and into other groups.

Takeaway: 2021 is not 2000, but let’s remember why they are at least similar. Now, as then, non-Tech groups have been out of favor for many years. The recent run for cyclicals does little to change that. Now, as then, we’re coming off a year of simply extraordinary enthusiasm for all things Tech. Bottom line: 2000 is a useful reminder that capital does move to traditional value sectors when growth names aren’t working anymore.