Investors strongly disagree with Powell’s optimistic interest rate guidance

The process of unwinding the emergency support measures, dubbed the great unwind by some sensationalists, which were introduced at the onset of the Covid-19 pandemic last year is taking shape. Naturally, forthcoming central banks’ monetary policy meetings will be extremely important. Investors will be studying the meeting minutes with a fine-tooth comb in search for clues. The CME Group FedWatch Tool, which extracts unconditional probabilities of the Federal Open Market Committee (FOMC) meeting outcomes from 30-day federal funds futures (FF) futures prices is likely to be handy as it provides an objective insight on investor’s rate expectations. A full description of how the probabilities are calculated is found is here. But beware of having a headache after reading it.

 

Interestingly the market is currently disagreeing with Powell’s view that interest rate hikes are a distance away. The FedWatch tool is attaching a 61% probability that the Fed fund rate will be higher than the current 25bp by as early as June. In other words, most of the Fed funds futures contracts are baking in a rate hike of at least 25bp in the Fed’s June 2022 meeting. Notably, calculator shows that there is a 60% chance that the target rate will be between 50bp and 100bp in 2020, implying rate hikes of 25bp to 75bp next year.

 

The market’s bearish rate outlook (relative to the Fed’s chair) is very understandable. While the US Fed expects inflation to be transitory, the temporary drivers such as pent-up demand and economic restart have subsided, and more sticky issues are emerging that might give inflation strong legs to be durable. Supply Chain bottlenecks and labour shortages pose the biggest risk, with supply shortages getting more pervasive causing spikes in energy, agricultural products and second-hand cars. On labour shortages, multiple data points seem to suggest that the problems within the EU and US labour market are more than search frictions. Expectedly investors have raised their inflation expectations with the widely followed Fred 5-year, 5-year forward inflation expectation rate remaining sticky above the Fed’s worry rate of 2%. Even break-even inflation rates are signalling similar outcomes. 

Source: The CME Group