We will confess to having a chuckle this morning when we realized that the US Federal Reserve was kicking off a 2-day meeting on May Day. Workers of the world, what should interest rates be? If only the Fed could extend their deliberations until May 5th, they could conclude on Karl Marx’s 200th birthday. And yes, that’s also Cinco de Mayo. It’s a busy week…
Now, market expectations for this Fed meeting are straightforward. No rate hike on Wednesday, but a more hawkish communiqué. Fed Funds Futures put the odds of a 25 basis point rate hike tomorrow at 6%, or about the same as flipping heads 4 times in a row on a coin toss. Which is to say unlikely, but not impossible.
While the debate over how many more times the Fed will increase rates through 2018 rages on, we’re unlikely to get all that much clarity from Wednesday’s press release. For the record, Fed Funds Futures make 41% odds of two more bumps (to 2.0 – 2.25%) and 40% for three increases (to 2.25 – 2.50%). That indecisiveness exactly mirrors the Fed’s March 21st “Dot Plot” of their expectations.
What matters more to markets is this question: “Where will Fed Funds be at the end of 2019?” Will we have to relive the “3 vs. 4 rate increases” debate next year as well? This hasn’t been a friendly narrative for US stocks this year, although high valuations and twitchy long-term rates haven’t helped either.
Here are three ways to think through this question:
Method #1: Follow the Fed. This is what the Fed’s last “Dot plot” had to say on Fed Funds at the end of 2019 (all these calculations assume the Fed moves only in 25 bp increments):
- The median expectation (and 5 of 15 “Dots”) among policymakers is for Fed Funds to reach 2.9% in December 2019.
This implies either 1 or 2 rate increases next year, depending on whether the Fed moves 2 or 3 more times in 2018.
- The second largest cluster of estimates (3 of 15 “Dots”) sits at 3.4%.
This scenario envisions the Fed moving 3 or 4 times in 2019, again depending on how many times they bump rates in 2018.
Essentially, the “Dots” show two schools of thought at the Fed: one believes we’ll be mostly done this year (the 2.9% camp) and the other thinks 2019 will see just as many rate increases as 2018. That’s a philosophical gap you could drive a truck through, and still have room for another truck.
Method #2: Look at the Fed Funds Futures. The data here:
- As of Tuesday afternoon, the price of the December 2019 futures contract was 97.375. Subtract that from 100, and you get a point expectation of 2.625% Fed Funds.
- The price for December 2018 contracts implies a point estimate of 2.19%, a difference to 2109 of 0.44%. Somewhere between 1-2 rate hikes in 2019, in other words.
The math here says futures traders are broadly in the same camp as the dovish group at the Federal Reserve.
Method #3: Look at short term Treasuries. Fed policy expectations deeply inform 1-3 year T-bill/note prices. The data here:
- One-year Treasuries yield 2.25% today
- Two-year Treasuries yield just 25 basis points more, or 2.50%
The upshot: Treasuries agree with the Fed Funds Futures market and the dovish Fed group. The bulk of the Fed’s moves come in the next 12 months (mostly in 2018). Next year may have one more move, but not much more.
Now, if you’re thinking that 2.5-3.0% Fed Funds seems a little low this late in an economic cycle, history will agree with you. The peak rate for the last cycle was 5.25% (1H 2007). The 1990s cycle topped out at 6.5% (2H 2000). In the late 1990s, Fed Funds were 9.8% (1H 1989).
Throw some inflation adjustment on those old rates, however, and you see the scope of the Fed’s Gordian’s Knot over the next 2 years. Real Fed Funds (rates less CPI change for our purposes) look like this across the last 3 cycle peaks for nominal rates:
- 1989: 5.1% real Fed Funds
- 2000: 3.1%
- 2007: 1.2%
The downward trajectory for real Fed Funds rates is clear, but what should it be in this cycle? Google “r star” (econo-speak for real Fed Funds rates) and you’ll see numerous Fed papers and talks on the subject. The bottom line here: no one knows.
The upshot to all this: there is going to be a real fight between markets and the Fed over where rates end up in 2019. Treasuries, Fed Fund Futures, and (by extension) equity markets believe the Federal Reserve should be done with its rate cycle this year. At least some policymakers aren’t so sure.