It turns out the market is not so sure after all. Investors were cocksure heading into 2017 about the prospects for an economic revival in the coming year that would not only spark higher inflation but also induce the U.S. Federal Reserve to raise interest rates two if not three times before the calendar year was out. But after getting just one month of the new year under our belts, it turns out that wild optimism about the rapid pace of transformational economic change is slowly giving way to the reality that things will take much longer to play out than the market had been expecting. The 2017 edition of the long slow fade surrounding Fed rate hike expectations is now underway.
The Song Remains The Same ... Same ... Same ... Same ...
"You don't know what you're missing, now
Any little song that you know
Everything that's small has to grow
And it's gonna grow, push push, yeah"
- The Song Remains The Same, Led Zeppelin, 1973
It is worth noting that the global economy is showing signs of measurable improvement. This includes an acceleration in economic growth expectations across much of the developed world and a strong acceleration in global leading economic indicators since early last year. We have also seen a pick-up in production and manufacturing activity in many parts of the world.
We have also seen a rise in inflation expectations corresponding to the improved economic outlook. In the United States, for example, we have a 10-year breakeven inflation rate that has jumped from lows of 1.2% at this time last year to over 2.0% today.
Overall, the data is confirming the narrative. Economic growth is accelerating. Check. Inflationary pressures are rising. Check.
The logical next step then is for the U.S. Federal Reserve to move to begin steadily raising interest rates in working to finally normalize monetary policy after years of extraordinary accommodation. The path has been set for policy and markets to finally get back to normal after so many years.
But in a notable divergence, this is not the path that the Fed appears to be heading. Sure, it goes out on the speaking circuit and talks a great talk about how "every meeting is live" and that "conditions are in place to support an interest rate hike at their next meeting". But the Fed has established a post-crisis reputation for never walking the walk when it comes to hiking rates. And an examination of market expectations about the Fed's future direction on interest rates suggests a slowly diminishing likelihood that it will even deliver on the two to three rate hikes that so many had written in as given heading in 2017.
Slowing Fading Away
To date, the U.S. Federal Reserve has managed to secure two 25 basis point interest rate hikes in moving off of what was effectively the zero bound. But these rate hikes have come at an excruciatingly slow pace so far with these hikes taking place in a year apart over the past two Decembers.
So what's next for the Fed on its journey to normalizing interest rates? Let's take a look at the latest numbers from the CME Group 30-Day Fed Funds futures to see what the market is currently expecting from the Fed on the interest rate hiking front in 2017.
To begin with, we will continue with the assumption that the Fed will only consider hiking interest rates at its FOMC meetings that are followed by press conferences where current Chair through February 2018 Janet Yellen can explain to the markets with coddling reassurances the exact thinking behind any potential rate hike. These include the gatherings scheduled for March 15-16, June 14-15, September 20-21, and December 13-14. The Fed may insist that it will consider hiking rates at its other non-press conference meetings, but this just isn't going to happen unless something currently unforeseen and absolutely crazy starts to take hold.
Let's begin with the next meeting that is supposedly "in play" on March 15-16. At the start of the year, just one short month ago, the markets were assigning roughly a one-in-three to one-in-four chance, or 29.5%, that the Fed would raise interest rates by 25 basis points at its next press conference meeting. Where do we stand just over 20 business days later in early February? The market is now only assigning an 8.9% chance for a rate hike in March. I'll do the market and any denying Fed policy makers 8.9 percentage points better by saying today that a rate hike in March isn't going to happen.
What about June? Just one month ago, the markets were assigning a 71.2% chance that the Fed would raise interest rates by at least 25 basis points by then. Just one month later, this probability has fallen back to 64.7%. These are still two-in-three odds for a rate hike by June, some might understandably say. But this meeting is still 18 long weeks away, and as we have seen so many times during the post-crisis period, what the market thinks the Fed might do four months from now almost always ends up very different than what actually takes place. And given that many in the market are still operating under the delusion that fiscal policy changes such as tax reform, stimulus spending, banking deregulation, and healthcare repeal are all going to happen simultaneously, immediately and go over wonderfully, I would counter by suggesting that the actual odds for a Fed rate hike in June are probably measurably less than half at this point and likely to continue to fade as we count down the weeks into spring and toward the summer.
Let's continue on to September. The market seemed nearly convinced at an 85.7% probability coming into the year that we would see at least one 25 basis point interest rate hike from the Fed by the time it was emerging from its September 20-21 meeting. But after only a few weeks, we are seeing doubt slowly seep its way into this view. For today, the market is now assigning a notably less 78.8% chance to such an outcome. This is still a very high probability at just over three-in-four, but certainly less than the six-in-seven odds we were seeing just a month ago. Moreover, seven months is an eternity when it comes to predicting what the Fed might do with interest rates. After all, a lot that is anticipated might not happen and a lot that is currently unforeseen may end up happening between now and then. As a result, I would place the odds of a Fed rate hike at a little better than half today but would not be at all surprised if the Fed stays on hold by the time this meeting finally comes to pass as the seasons change to the fall.
What about the last meeting of the year in December? After all, it has been this meeting over the past two calendar years where the Fed has felt emboldened enough to act with a 25 basis point rate hike. This will also be the last press conference meeting before the presumed departure of current Chair Yellen from her post. It is also very possible that two or perhaps even three new appointees to the Board of Governors will have been added by the new administration. In other words, not only do we not know how the economy or the geopolitical landscape will be unfolding at that time, but a measurable degree of uncertainty exists surrounding the policy perspectives and priorities of those that make up the Fed will be at this point.
With all of this in mind, the market is currently pricing in a 92.9% probability of at least one 25 basis point interest rate hike from the Fed by December. This is down slightly from the 95.2% probability coming into the year, but is still very strong. It is, of course, a long 10 months away as well.
What about the potential for more than one 25 basis point rate hike by December? While the market is currently pricing a 36.7% chance for at least two rate hikes by its September meeting, this is already way down from 50.0% at the start of the year and I expect this number will quickly head toward zero as the year progresses. And if we don't have two rate hikes by September, the current 30.6% probability for three quarter point hikes by December, which is also down from 43.3% just a few weeks ago, is also likely to go to zero in the coming months.
Thus, the debate is shifting to whether we will see two 25 basis point interest rate hikes from the Fed by December. At this point, the market is pricing in a 66.3% chance for two rate hikes by the end of 2017, which is also down from 75.4% at the start of the year. In short, still very possible, but expect more to get chipped off of this number as the weeks continue to roll by.
Why Fade Away
If the sustained economic growth story is building and inflation expectations are rising, why are expectations about a Fed rate hike heading in the other direction? Because we have seen this story so many times before during the post-crisis period. The long anticipated economic recovery is always coming "in the second half of the year" if it's the winter or spring or "early next year" if it's the summer or fall. But time and time again, it never materializes. And the reason that sustained economic growth and inflationary pressures never materialize is that it is unhealthily dependent on the steady flow of monetary stimulus from central bankers to perpetuate the illusion that the economy is even as good as it appears to be. Take away the guise of monetary stimulus and the global economy is left to stand naked to reveal its distorted and disfigured reality.
Policy makers are once again working in 2017 to slowly remove the veils from the global economy with the hopes that forces of inflation will finally prove sustainable and that fiscal policy may finally be ready to fill the gap, but after so many post-crisis years and false starts along the way, they are almost certainly going to proceed tentatively and with extreme caution along the way.
The Bottom Line
The debate heading into 2017 surrounded whether the Fed would raise interest rates by 25 basis points two or three times this year. But after only a few weeks into the new year, the discussion has already shifted. Now, it is a question as to whether it will raise rates twice this year. And expect in the coming months for this debate to evolve further to whether the Fed will hike once or twice by the end of the year. And by the time December rolls around, do not be surprised if the market is wondering once again whether we will see another annual 25 basis point rate hike by the Fed before another year gets away from us. The nature of this last debate will depend, however, on what actually takes place with the economy over the coming year along with exactly who is serving on the Board of Governors and who is set to take over the Fed in early 2018. In short, a lot is set to take place on the monetary policy front that will be worth watching over the next 10 months, but it will bring with it added uncertainty as to what the Fed will actually do along the way.
So what does all of this mean for capital markets? While good news on the economic and corporate earnings front is likely to provide short-term jolts to stocks (NYSEARCA:SPY) at the expense of bonds (NYSEARCA:BND) and gold (NYSEARCA:GLD), these advances may not prove sustainable. This is due to the fact that stocks (NYSEARCA:DIA) are still priced at historical premiums and have already priced in years' worth of anticipated good news that has never materialized in any sustainable way to this point. On the flip side, expect the "bad news is good news" narrative to make a comeback as the year progresses, which will provide support to stocks (NASDAQ:QQQ) but likely a greater boost to bonds (NYSEARCA:AGG) and precious metals (NYSEARCA:PHYS) that have been sold off on higher interest rate expectations for the coming year that may ultimately not materialize anywhere close to what the markets originally thought.
Taking this one step further, if global central bankers outside of the U.S. increasingly take their foot off of the monetary policy accelerator as expected in 2017 and global economic growth does not continue to accelerate as currently anticipated, this will leave stocks exposed to at least a partial deflation of the nasty air pocket that has formed underneath valuations for so many years in the post-crisis period. Beyond being decidedly bearish for stocks if this were to come to pass, it would be equally bullish for Treasuries (NYSEARCA:TLT) and gold, along with a series of increased fits of volatility (NYSEARCA:VXX) along the way.
With all of this in mind, stay long stocks, but stay watchful, stay defensive, stay diversified both within stock portfolios and broadly across asset classes, and stay mindful of risk management all along the way in the coming year.
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 am/we are long TLT, PHYS.
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.
Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.