We released our Fed Watch report on Nov. 7, which showed in early November that the market expected the Fed to do the following:
- increase interest rates in December 2017
- increase them again by October 2018
- increase them again by February 2020
What Has Changed Since?
The Fed just increased interest rates by 25 basis points at the December 2017 meeting, as expected. The second hike of 25 basis points is now expected earlier, by June 2018. The third hike of 25 basis points is also now expected earlier, by March 2019. Additionally, the odds of the fourth interest hike have increased to around 50%, by February 2020.
Here is a chart that shows the comparison between the Nov. 7 expectations (red line) and the Dec. 14 expectations (blue line). The chart is derived from the CME federal funds futures.
A Slightly More Aggressive Fed
Practically, the market's expectations have not significantly changed over the last five weeks. The Fed is now expected to be only marginally more aggressive in 2018. However, the 2% ultimate ceiling for the policy rate normalization is solidly in place.
Public Policy Projections
The Fed continues to publicly project three interest rate hikes in 2018, where the median projection for the federal funds rate is at 2.1% at the end of next year. Thus, there is a significant difference between the market expectations for short-term interest rates and the Fed's public policy projections for 2018.
The disconnect between the market's expectations for the federal funds rate and the Fed's public projections for the interest rate policy is likely to result in higher volatility next year. Here are two scenarios:
The market's expectations for short-term interest rates rise in order to reflect the Fed's projections. In this scenario, the obvious trade is to short federal funds futures or the two-year T-bill, or short the iShares 1-3 Year Treasury Bond ETF (SHY). Rising short-term interest rates are consistent with the late-cycle trade, which would still benefit the overall stock market (SPY). Additionally, the U.S. dollar (NYSEARCA:UUP) would likely rise.
The Fed is forced to disappoint the market and lower projections in line with current market expectations. The major beneficiaries of this scenario are gold (GLD) and silver (SLV), as well as currently out-of-favor miners (GDX)(SIL). If the fundamental reasons behind such a possible downgrade in the Fed's projections are related to the disappointing economic news, the stock market's valuations would have to reflect the reality and significantly contract. That could cause a major correction.
In our opinion, the second scenario is more probable, as it's difficult to assume that market expectations would be so inefficient -- despite the constant reminder from the Fed.
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.