Latest Gaze Into The Fed's Crystal Ball

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Includes: HYG, SPY
by: Eric Parnell, CFA

Summary

The Fed entered the New Year with a bold plan for as many as four rate hikes in 2016.

Today, perhaps not so much.

What is the latest market read on what the Fed will actually do in the months ahead?

The Fed entered the New Year with a bold plan. Over the course of the next twelve months, the U.S. central bank was strongly suggesting its intent to carry out four quarter point interest rate hikes. But since the start of the year, the global economy has continued to sputter, the stock market has dropped like a stone and previously latent risk factors have suddenly surfaced to grab the attention of investors. Although the Fed continues to try and talk a good game about their determination to raise interest rates, what is the latest market read on what the Fed will actually do?

As mentioned in my previous update on the topic from one month ago, the four dates that the Fed is most likely to raise interest rates are following its March, June, September and December Open Market Committee meetings that are followed by press conferences. So while the market is currently pricing in a 12% probability that the Fed will hike rates at their meeting next Wednesday, January 27, I am assuming that there is zero chance that this will actually happen.

The Ides Of March

Our first look ahead is to the Fed's next press conference FOMC meeting on March 16. According to 30-Day Fed Fund Futures from the CME Group, the market is currently pricing in a 32% probability that the Fed will increase interest rates by at least 25 basis points coming out of this meeting. It is worth noting that this represents a 22 percentage point drop from the 54% probability the market was assigning to this meeting just one month ago.

With expectations having fallen to a one-in-three chance for a Fed rate hike in March, the first conclusion that we can draw is that idea of four rate hikes in 2016 is already moving off the table.

Let's continue forward to the next press conference meeting on June 15. The futures market is now pricing in a 52% chance for at least one 25 basis point increase by June. Once again, this is down 22 percentage points from the 74% probability that was being assigned just a month ago. Put more simply, if the Fed does not hike in March, the market is still pricing in just over equal odds that the Fed will raise in June.

What about the chance for a second rate hike in June if the Fed moves in March? The market is now pricing in only a 13% chance for back-to-back press conference meeting quarter point rate hikes, which is down by more than half from the 28% expectation just one month ago. From a conditional probability perspective, this implies only a 40% chance that the Fed will hike in June if it ends up pulling the trigger in March.

This leads us to our second conclusion, which is that it is believed that the Fed may also seek to spread out its rate hikes going forward, at least in the near-term.

Moving ahead to the next press conference gathering on September 21, we find a 65% probability that the Fed will have carried out at least one more 25 basis point interest rate increase by the conclusion of this meeting. Once again, this is down 21 percentage points from the 86% probability assigned by the market one month ago.

The odds for two rate hikes by September? It is now just 24%, which is also down by more than half from the 50% expectation just one month ago. And the odds for three hikes by September? It has dropped all the way to less than 5% versus 17% a month ago.

This provides us with our third conclusion, which is that the market seems to maintain the belief that we will see at least one more rate hike in the coming months, but any further rate hikes beyond that are still very much up in the air.

On to the meeting at the end of 2016 on December 21. The market is assigning a 73% chance of at least one rate hike by then. Although this is down from the previously near certain 92% probability, it is still notably high at a three-in-four chance. How about two rate hikes by then? The probability falls to 34%, which implies just over a one-in-three chance that we will see two rate hikes in 2016. Three hikes by December? Just 10%. As for the grand slam of four rate hikes? The probability is now less than 2%, which is down sharply from the 11% probability from one month ago.

This leads us to our final conclusion, which is not stated but instead implied by the futures data. Markets are currently pricing in a three-in-four chance for one more rate hike by the Fed in 2016 to add to their first rate hike in December 2015. And they are pricing in a one-in-three chance that we will see two more rate hikes in 2016. As for the odds for three or four hikes in 2016, they are quickly falling to zero. But what is notably still missing from these probabilities is the following - the market is still assigning a zero percent chance that the Fed will lower interest rates at some point between now and the end of 2016.

Bears Beware

Bears should understandably view this meaningful drop in probabilities surrounding future Fed interest rate increases as vindicating, as it is basically proving out their long held claims that the underlying economy is simply not strong enough on its own without Fed policy support to sustain the economy and stock prices at current valuations. But in what may be a counterintuitive perspective, the bears should view the current state of these probabilities and the fact that they are in decline with caution. For what it implies is that the Fed currently has a lot of room to jawbone the market's expectations about interest rates lower before it has to take any actual action. And as we have seen over the past eight years, the market has certainly shown the propensity to perk itself up the moment it receives some reassuring words about additional support from the Fed.

Such jawboning may not stem the overall market decline at the end of the day, but it has the potential to bring rise to staggeringly and unexpectedly sharp stock market rallies at any moment in time. At the end of the day, the only thing outside of sustainably strong economic growth (still miles away) that will likely elevate stocks back into their upward dream state is daily Treasury purchases from the Fed (i.e. QE4), but this does not mean that the market won't be prone to positive knee jerk reactions to various insinuations about stimulus by the Fed along the way.

As a result, bears must remain on watch as they navigate what appears to be a gradually accelerate move to the downside in the stock market (NYSEARCA:SPY) and its correlated asset classes such as high yield bonds (NYSEARCA:HYG). For it may be wise to lock in at least some gains on short positions as they are accumulated to the downside, as the Fed will likely provide the bears with the opportunity to reload their inverse allocations on the upside rips that follow their attempts to reassure the market.

It promises to be an interesting year ahead, not necessarily for the further interest rate movements from the Fed, but instead for the wild market swings that we are likely to see in the coming months.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.