The U.S. Federal Reserve stirred capital markets on Wednesday with the release of the minutes from their most recent meeting in April. What startled the market was the fact that the Fed through their discussions explicitly stated a much higher likelihood for a rate hike in June than expectations. The result of the minutes was the following - the market now knows that June is back on the table. But it really should have never been off the table in the first place. And just because June is on the table, does not mean the Fed will actually move to hike rates next month.
The Minutiae From The Minutes
The market had previously been fairly sanguine that the Fed would not be hiking interest rates in June. For example, on Tuesday before the release of the Fed's minutes from its latest FOMC meeting in late April, the market according to the CME Group 30-Day Fed Fund futures was only pricing in a 15% probability of a 25 basis point rate increase coming out of their next meeting on June 15.
But then, the minutes were released. And here were two of the key explicit statements that likely grabbed the attention of capital markets:
"Federal Reserve communications following the March FOMC meeting were interpreted by market participants as more accommodative than expected... On net, financial market quotes implied that the federal funds rate path expected by investors flattened notably, and that their estimated probability of a rate hike by the June FOMC meeting declined significantly."
"Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June."
Let's bottom line these comments in the minutes. The Fed was surprised that the market (NYSEARCA:SPY) took a June rate hike off the table coming out of their last meeting in March, and they wanted to make it explicitly clear that June is still indeed on the table coming out of their latest meeting in April.
Two brief observations
First, I'm not sure that the Fed should be so worried about how the market is interpreting their communications at any given point in time. Perhaps the Fed should just go ahead and do what it feels it needs to do and not worry so much about the market. If the market gets it wrong, that's risk-taking investors' problem, not the Fed's. And maybe the Fed rattling the cage of investors every now and then with an unexpected jolt might be helpful in getting investors to think a bit more carefully about the risks that they are undertaking at any given point in time.
Second, nobody should have ever concluded that the June meeting was off the table anyway. Today's global economy and its capital markets are incredibly dynamic and can change in tone and apparent direction from week to week if not day to day. Back in mid-February, many were worried that the market was about to collapse. A few weeks later, others were speculating about new all-time highs. Given the bipolar nature of today's capital markets, investors should recognize that the possibility is always open that the Fed will make changes a few weeks out that may not be readily apparent today.
But back to the data.
How Much More Likely Is The Fed To Hike Rates?
Despite the market stirring reaction to the latest Fed minutes, it still remains fairly unlikely that the Fed is going to raise rates in June. This could certainly change over the next month between now and their actual meeting, but the probability is still very much in favor of the Fed staying on hold in June.
To this point, on Wednesday after the release of the Fed minutes, the CME Group 30-Day Fed Fund futures was pricing in a 34% probability of a 25 basis point rate hike in June. This represented a 19 percentage point increase from the 15% reading heading into the release of the minutes. But despite this increase, it still implies a roughly two-thirds likelihood that the Fed is NOT going to raise rates in June.
In other words, just because the Fed made sure the market knew that June was a possibility for a rate hike does not at all mean that they are actually going to follow through with it. Instead, because they are the Fed that cares so much about markets, they wanted to just make sure the market knew something that they should have already known anyway.
So if the Fed does not move in June, what about future months? The probability for at least one rate hike by July increased from 33% to 56% following the release of the minutes, but July is not an FOMC meeting followed by a press conference. Perhaps I am wrong, but I remain doubtful that the Fed will hike rates at a non-press conference meeting. The only exception I could see here is if Janet Yellen in her post-June meeting press conference figuratively beats investors over the head with the high probability that they may hike in July. This will be something worth watching for coming out of the June meeting.
Going further out to the next FOMC meeting with a press conference in September, the market is now pricing in a 67% probability of at least one interest rate hike by then, including a 22% probability for at least two rate hikes. This is up from 49% and 11%, respectively, prior to the release of the minutes. While I see one rate hike between now and September as a real possibility, anything more than that would be highly ambitious and very unlikely given the ongoing uncertainties for the global economy along with the fact that we will be in the heart of the general election for the U.S. presidency at that point. Moreover, the potential remains for the outbreak of a meaningful stock market correction along the way between now and September. In short, maybe one rate hike, but almost certainly no more than one by September.
What about the next press conference meeting after the election in December? The market is now pricing in a 79% probability for at least one 25 basis point rate hike by the end of the year. This includes a 40% probability for at least two rate hikes and even a 11% probability for at least three rate hikes. These are up from 71%, 29%, and 6%, respectively, prior to the release of the minutes. I share the view that the probability for at least one rate hike by December is high, although it may not come until December and will depend a lot on the direction of the global economy over the next six months. And while I also think that two hikes stand a decent chance by December, I would meaningfully lower this probability if the Fed does not hike in June or July.
The Bottom Line
The Fed has succeeded in making the market aware that the June rate hike is a real possibility. For those of the view that the Fed should keep markets clued in on what they are thinking about doing at any given point in time, this was good work.
But in making this adjustment, the market has now shifted to a more hawkish mindset around what the Fed might do with additional rate hikes in the coming months. The market is now assigning meaningful probabilities to interest rate hike paths that are likely more ambitious than what the Fed will actually do. One rate hike by December? Sure. Two by December? Probably, not unless the Fed hikes in June. A rate hike in June? Maybe, but I still doubt it. Two rate hikes by September? C'mon now.
The key takeaway for the markets from this now more hawkish view is the following. Previously, the markets had taken on an overly dovish bias, which set up risk assets for disappointment and sudden drops in prices as a result. But now that the Fed has stirred the market toward a more hawkish bias, the potential is now open for the markets to be pleasantly surprised, which leaves open the possibility for Fed jawboning and sudden increases in prices as a result.
We may not like the continuously active role of the Fed in today's markets (I for one greatly dislike it), but it remains a reality. As a result, it is worthwhile to monitor their moves and adjust accordingly to both their quantitative and qualitative actions at any given point in time. And the latest release of the FOMC minutes from April has been no exception.
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