Gauging the Likelihood of a Fed Funds Hike
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"Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more."- Investors Are Grossly Underestimating the Fed
My advice to plan for the unexpected was prescient. When I wrote the article in July 2019, Fed funds were between 2.25% and 2.50%. The Fed funds futures contracts were implying the Fed would reduce rates by .75% in the forthcoming months.
By April 2020, Fed funds were trading near zero, 1.50% below where the market thought they would be in mid-2019. The article quantified the history showing that the Fed always raises or cuts rates much more than expected.
Today, the market is pricing in steady increases for the Fed funds rate, starting in 2022. Yet, despite high inflation and low unemployment, the Fed refuses to think about thinking about raising rates.
Given the Fed's posture, traders are overestimating how much the Fed will raise rates. However, I caution once again; traders always underestimate the Fed.
Whether higher Fed funds is logical is irrelevant. As investors, we need to strategize in case history proves clairvoyant. Given the Fed is starting to normalize monetary policy, it's worth revisiting the above referenced article from 2019.
I recommend reading the article's first section for more background on Fed funds and their futures contracts.
The graph below shows how much the Fed funds futures market consistently over or underestimates what the Fed does. The green areas and dotted lines quantify how much the market underestimates how much the Fed ultimately reduces rates. The red shaded areas and dotted lines are akin to today's potential rising rate situation. They show estimates for rate cuts fall short of the Fed's actual actions.
Per the article:
As shown in the graphs above, the market has underestimated the Fed's intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.
The good news, with rate increases on the horizon, is the market's margin of error for rate increases is much less than for rate decreases.