Rate hikes: Timing is Everything

Written by: Global Thought Leadership | January 05, 2018

Source: Bloomberg and Legg Mason, Jan 4, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line

  • Will the Fed’s expected rate hikes this year continue to head off inflation without stunting growth? Or is a policy error possible – with tightening more quickly than the economy can bear, or slower than inflation warrants?
  • One possible answer may be hiding in plain sight, in the prices of the futures market for Fed Funds – the interest rate at which the Fed lends to banks overnight.
  • Examining the pattern of prices of these futures contracts at each of their expiration dates provides a useful picture of what traders believe – at least for the moment – will be the timing of rate hikes at each of the ten FOMC meetings scheduled in 2018.
  • Fed Funds futures are famously fickle – the probabilities can fluctuate furiously each day, depending on shifting expectations.  But as a reading of each day’s expectations, these market prices still send clear signals about current expectations.
  • For instance, the price pattern1 for Thursday, January 4 reflects expectations of two quarter-point hikes in 2018 on March 21 and June 13, dates marked in yellow on the chart. The rate/timing path is marked in green, and would result in a target rate of 2.0% for the remainder of the year, 50 basis points above the current level.
  • However, the second most likely path would have the Fed make three hikes instead of two, with the third taking place at the conclusion of the September 26 meeting, also in yellow; the third most likely would forego a hike at the June meeting, leaving the rate at 1.75% at year’s end. The implied odds of the first hike taking place on January 31 currently stand at 0.0%; the odds of a March hike stand at just over 81%.
  • All this is potentially good news for fixed-income investors who fear the impact of a policy error; the futures market seems to expect a moderate path for the coming year, both in terms of level and rate of change.
  • The bottom line: if the FOMC continues to get it right, a Goldilocks scenario could continue to unfold: positive inflation-adjusted income for investors combined with sustainable growth.

1 Source for all figures: Bloomberg, January 4, 2017.

 

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