Markets Believe The Rate Hike Cycle Has Ended

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by: Sankalp Soni
Summary

The Fed has kept rate hikes on hold since the start of this year amid weakening economic conditions.

The front-end of the yield curve remains inverted, while other sections remain very flat.

Probabilities of rate cuts are surging according to fed funds futures, while chances of rate hikes are diminished, suggesting that the rate hiking cycle could be over already.

The Fed hiked rates four times in 2018, and the current fed funds rate target range is at 2.25%-2.50%. Though amid weakening economic conditions, both globally and domestically, the Fed has paused with further rate hikes. Given that the economy has not shown much improvement lately, market participants increasingly believe that the Fed has already reached the end of its rate hiking cycle, and will certainly not be able to hike rates in 2019. We will assess what certain indicators are signalling presently.

Front-end of the yield curve remains inverted

The chart below demonstrates the how the 1yr and 2yr treasury yields have mostly been falling since the start of this year, indicating that treasury investors are lowering the odds of further rate hikes by the Fed.

Source: CNBC

Furthermore, the treasury yield curve is also inverted at the front-end, with the 1yr yield (currently 2.52) above the 2yr, 3yr and 5yr yields, and the 2yr yield (currently 2.46) also above the 3yr and 5yr yields. Though the main section of the yield curve that investors watch is the 2yr and 10yr. This section of the yield curve is currently very flat, with the spread at around 16 basis points (at time of writing). If the 10yr falls below the 2yr yield, it is considered a recession signal. The logic behind this being that lenders become reluctant to make long-term loans, as it becomes unprofitable to borrow at the short-end of the curve, and lend out at the long-end of the curve, and thereby tightening credit market conditions.

The inverted and flat shape of the yield curve remains a major concern, as even the Fed mentioned it in their latest minutes from the meeting in January.

The Fed minutes claimed that:

Several participants also noted that the slope of the Treasury yield curve was unusually flat by historical standards, which in the past had often been associated with a deterioration in future macroeconomic performance.

Hence, the Fed is clearly concerned over the shape of the yield curve, which could inhibit them from further raising rates this year. In fact, while many investors watch the 2yr/10yr section of the yield curve closely, I believe it is worth mentioning that the spread between the 1yr and 10yr yield is even more concerning, currently at around 10 basis points (at time of writing). The 10yr yield has been plummeting lately, as future interest rate expectations fall amid a deteriorating economic outlook. Hence there is a good chance that the 1yr/10yr section of the yield curve could end up inverting before the 2yr/10yr section, if the economic outlook continues to worsen. Therefore, based on the adverse shape of the yield curve, the Fed certainly will not be able to hike short-term rates due to the risk of further inverting the yield curve, which would be followed by negative impacts on the economy and financial markets.

FedWatch reflects rising chances of rate cuts

Another important indicator is the CME Group’s FedWatch, which reflects the probabilities for rate changes by the Fed based on fed funds futures activity. Presently, FedWatch is reflecting a 0% chance of rate hikes for every single meeting up till January 2020 (at time of writing). On the other hand, the probabilities for rate cuts have been surging. At time of writing, there is a 22% chance of rate cut in December 2019, and a 31%% chance of a rate cut in January 2020. This is a notable jump, given that only a few weeks ago it was reflecting single digit probabilities for both these months. Moreover, the probabilities for rate cuts in September and October, which had been miniscule last month, have now spiked to 14% and 16% respectively.

Therefore, given that markets are increasingly preparing for rate cuts as opposed to rate hikes amid weakening economic conditions, it would be a big mistake for the Fed to try to signal more rate hikes ahead, as it would result in a spike in volatility in financial markets, as we had witnessed back in Q4 2018 when the Fed appeared to be tightening aggressively while ignoring markets’ signals that the economy can not handle more rate hikes. Keep in mind that the Fed does not necessarily need to actually raise the fed funds rate to stir up financial market volatility, but the mere mention by the Fed that they are considering one more rate hike in the second half of this year could prove enough to induce volatility and push short-term treasuries and stock prices lower. In fact, in their latest FOMC meeting minutes, the Fed mentioned the term ‘volatility’ nine times, reflecting increased concerns among Fed members over financial market conditions. Therefore, the Fed is unlikely to hike rates against market’s dovish expectations, in order to avoid inducing more volatility again.

Bottom Line

One of the biggest macro factors that investors need to take into consideration is the future path of monetary policy actions by the Fed. Amid continuous weakening in economic conditions; treasury yields, the shape of the yield curve, and FedWatch are all exhibiting a declining likelihood of the Fed raising rates any further from here, and in fact are reflecting increasing chances of rate cuts, which would suggest that the rate hiking cycle is over. Thus, if the Fed were to try and signal more rate hikes ahead against this backdrop of dovish expectations, it would result in a spike in financial market volatility again. Therefore, investors should keep a close eye on communication and guidance from the Fed following its meeting on Mar. 20, 2019, as it could potentially result in wild moves in asset prices if the Fed fails to deliver on dovish expectations again.

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.