- Global financial markets are changing their view on the path of likely interest rate increases from the US Federal Reserve — one of the most important
- Pricing in the overnight index swap market implies markets only expect two rate hikes from the Federal Reserve, rather than three or more.
- It’s a reflection of growing concerns that the US economy is at the end of its current cycle of growth, meaning the Fed won’t be able to tighten monetary policy as aggressively as previously thought.
SYDNEY — One month ago financial markets were positioned for a series of at least interest rates increases from the US Federal Reserve in the year ahead, continuing the gradual path of policy tightening that’s been in pace since late 2015.
But now doubts are creeping in.
As seen in the chart below from Capital Economics, after pricing in the likelihood of at least three further 25 basis point increases in the Fed funds rate one month ago, financial markets are now only pricing for two, based on current overnight index swap pricing.
A deterioration in some US economic data, increased caution from several leading Fed officials, including Chair Jerome Powell, a sharp lift in financial market volatility along with increased concern about the global economic outlook has clearly taken its toll on fed funds rate expectations, leading to noticeable shift lower in the level and when markets believe it will peak.
While broader financial markets are concerned about a pronounced slowdown in the US economy — reflected in part by an inversion of some of the US yield curve last week — Capital Economics remains sceptical on whether the economy will deteriorate to the level some in markets currently think.
“Despite the ongoing turmoil in financial markets and the inversion of some parts of the US Treasury yield curve, the incoming US activity data has actually held up well in recent months,” says Simona Gambarini, an economist at Capital Economics.
“As such, we still think that the Fed will raise rates three times between now and the middle of 2019, taking the fed funds target range to between 2.75% and 3.00%.”
Beyond that, Gambarini says the “cumulative effect of monetary policy tightening will start taking a toll on the US economy”.
“This will force the Fed to end its tightening cycle sooner than investors anticipate,” she says. “This is not yet discounted into the markets.”
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