In November 2014, this column noted that prices in the Treasury futures market were suggesting a federal-funds rate of 0.70% at the end of 2015. Back then, the central bank’s policy-setting Federal Open Market Committee projected that the rate would be as high as 1.4% by year end. The fed-funds rate—the overnight lending rate banks charge one another for funds maintained at the Fed—is currently 0% to 0.25%.
Cut to last Wednesday, following the FOMC’s latest meeting, when the Fed signaled there would probably be only one hike this year, instead of the two that officials previously expected. The FOMC’s median fed-funds-rate expectation for the year end is now 0.63%, and the average is 0.57%. Both are closer to what the futures market, not policy makers, predicted, so chalk one up to the market’s foresight.
Now what? Many economists and investors think the first hike will come in September, but the Treasury futures market continues to see a less aggressive rate environment than the Fed has forecast, both in the short and long term (see nearby chart). The futures indicate there’s a 52% chance the Fed will first lift rates in December. The probability of a September hike is just 17%.
The futures say a hike is “just a coin toss,” even as late as December, says Nicolas Colas, chief market strategist at Convergex. Some think it will come in September because the FOMC meeting that month will be followed by a regularly scheduled press conference with Chair Janet Yellen. But the Fed follows the data, not the press schedule, Colas notes.
The Fed’s expectations have come down dramatically, he adds. The Fed is now looking for 1.8% to 2% growth this year in U.S. gross domestic product, down from a projection in March of 2.3% to 2.7%. For year-end 2016, the median FOMC fed-funds projection is 1.63%, but the futures market puts the rate at 1.1%.
There is a potential political component to rate hikes that the Fed doesn’t acknowledge but most Fed watchers assume. Next year is an election year, and the central bank doesn’t want its interest-rate hikes to be politicized. It probably will want to be well into a tightening program before the election campaign begins in earnest.
When the Fed starts to tighten, why would bond investors wait for a “gradual” rise in rates, asks Bob Eisenbeis, chief monetary economist at Cumberland Advisors. If Treasury bonds are going to be marked down steadily, many holders could “run for the exits” in advance, he says. While some money could move into stocks from fixed-income assets, he says, a disorderly rout in the bond market is likely to rattle equity markets, too, particularly in the short term.
If the global economy continues to expand, even slowly, and the road to higher interest rates is long and gradual, history suggests stocks will weather the rate hikes after some initial selling. The smart money is betting that U.S. Treasury yields will stay lower for longer, still a broadly supportive backdrop for equities.