The markets are discounting the odds at effectively zero that the FOMC, at its meeting next Tuesday and Wednesday (Oct 31-Nov 1), will raise its funds rate target by +25 bp. The November federal fund futures contract (ZQX23) today is trading at a rate of 5.33% (i.e., 100 – current price of 94.67), which exactly matches the current effective federal funds rate of 5.33%.
By contrast, the markets as recently as August were discounting the chances at 62% for a rate hike at next week’s meeting. The main reason the markets are no longer looking for a rate hike next week is that the 10-year T-note yield since August has soared by about +70 bp to a 16-year high.
That rise in the 10-year T-note yield has done more of the Fed’s tightening work by pushing key longer-term interest rates higher, such as mortgage rates, auto loan rates, and longer-term financing rates for corporations. Several Fed officials have explicitly referred to the sharp increase in T-note yields as a reason they favor no change in the funds rate next week.
Still, the markets are not convinced that the Fed is finished with its rate-hike regime. The federal funds futures curve currently peaks at 5.41% for the February 2024 contract, which implies expectations for an +8 bp rate hike from the current effective federal funds rate of 5.33% and translates to a 32% chance of a Fed +25 bp rate hike in early 2024.
The markets are still leaving room for the outside chance of one more rate hike because the economy continues to show strength, and inflation has yet to show an adequate decline. U.S. payroll growth in the past three months has averaged a strong +266,000 and rose by an 8-month high of 336,000 in September, illustrating that U.S. businesses remain optimistic and are still actively hiring new employees. Also, today’s U.S. Q3 GDP report of +4.9% was very strong.
Meanwhile, the PCE deflator, the Fed’s preferred inflation measure, remained high at +3.5% in August on a nominal basis and +3.9% on a core basis, both far above the Fed’s +2% inflation target. Moreover, the inflation outlook has recently strengthened due to persistent strength in the U.S. economy and the Israel-Hamas conflict, which has pushed oil and gasoline prices higher.
However, the markets believe the Fed will be forced into cutting interest rates starting in mid-2024 due to a deterioration in the U.S. economy. The market consensus is that U.S. GDP growth will be barely positive in the first half of 2024, with Q1 growth of +0.2% (q/q annualized) and Q2 growth of +0.5%. The markets are then expecting a modest recovery in U.S. GDP growth in the second half of 2024 with Q3 growth of +1.3% and Q4 growth of +1.7%.
In response to a weak economy, the markets are expecting the Fed to cut its funds rate target by -61 bp to 4.72% by the end of 2024 and by an overall -93 bp to 4.40% by the end of 2025.
On the date of publication, Rich Asplund did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
