Fed Policy Expectations Still Matter

When equity markets focus on just one issue, as is the case with tariffs/trade wars just now, other critical drivers of asset prices fall off the radar. Then, when the smoke of the crisis-du-jour clears, attention bandwidth broadens again (for good or for bad). We’ve argued the bullish side of this paradigm in prior notes: trade and tariffs hold the floor now, but Q1 earnings will help US stocks later in March as attention shifts to very healthy corporate earnings growth.

Here’s the bearish argument, however: market uncertainty over Federal Reserve policy isn’t going to resolve itself any time soon. The next Fed meeting is two weeks away (ends March 21st). It will come with not just a rate decision but also an updated “Dot Plot” of participants’ rate expectations and also new Chair Jay Powell’s first press conference.

And as if he and the FOMC didn’t have enough on their plate, now they will have to address the potential impact of White House trade chatter on future monetary policy. Chair Powell will certainly get questions on this front at his presser, even though his only viable answer will be “We’ll have to wait and see how the issue develops and assess its impact on the US economy over time.”

Here’s what Fed Funds Futures currently predict for each of the four major US central bank meetings this year (prices as of Wednesday afternoon):

March: a 25 basis point increase is essentially a lock (86% odds). That will make 150 – 175 bp the new range for Fed Funds. Why isn’t this closer to 100% odds? Our best thought is that the March contract is a bit of a near-dated “disaster hedge”; if US equity markets hit a severe air pocket over the next 2 weeks, the Fed may put the March rate increase on hold.

June: markets make it better than 2:1 (70.1% odds) that the Fed will go again this month, raising rates to 175 – 200 basis points. The chance of no move in June is 23% (i.e. rates stay at 150 – 175 after the March bump).

September: odds for another rate increase at the end of Q3 (making 3 in 2018) to 200-225 bp are currently 47.6%, essentially a coin flip. Odds that the Fed stays at 175 – 200 bp or didn’t even raise rates in June are collectively lower at 44.0%,

December: when we get this far out, the distribution of probabilities gets notably wider. Highest odds here are for three rate increase in 2018 (to 200-225 bp) at 40.1%. The odds of four or more rate increased (a concern for equity investors just now) are now 33.7%.

Summing up: Fed Funds Futures predict three Fed rate increases in 2018, so that’s what is baked into stock and bond prices just now. However, the chances that the central bank moves four times or more are a non-trivial 33.7%. Markets may be ultra-focused on the trade issue just now, but with Chair Powell’s first FOMC meeting coming up soon, we’ll be watching this number just as closely as reading the tea leaves from the White House.