Wednesday is Fed day. At 2:00 pm, they will announce their new target Fed Funds rate.
This meeting is likely to be a non-event. Everybody and their best friend think the Fed will increase their target short-term interest rate by 0.25%. This increase will bring the target rate to a range of 4.50% to 4.75%. The Fed pushes rates to their target level by reading where investors want to take them and where they want them to go. By telegraphing a rate, they hope investors get on board and price short-term securities appropriately. They are using a bullhorn to get people to do what they want. If that does not work, they interview in the marketplace. If they wish for rates to rise, they sell securities. If they want rates to fall, they buy securities.
The table extracts data from the Fed Funds Futures market. By applying a little math, one can determine what is in current market prices. As shown in the table above, there is a 99.8% chance rates will rise by 25 basis points on Fed 1. Furthermore, there is an 82.5% chance they will raise again after the March meeting. Notice that people are pricing a slight chance that the Fed will hold short-term rates constant. The outcome of the May meeting is more uncertain. Presuming the Fed increases rates by 25 basis points after the next two meetings, there is a 54.6% they do nothing and a 35.5% chance the Fed will raise rates one more time. After that, The Fed Funds Futures traders are signaling the Fed will be done, and the systematic increase of rates will be over.
When will the Fed start cutting rates again? That is quite uncertain. The Fed Funds Futures prediction look more like the result of a shot gun blast. The forecast is all over the place. What ultimately happens in the months ahead will depend on the labor market and the inflation rate.
We have another way of predicting the Fed Funds Rate. We compare it to the yield on 1- Year US Treasury Securities. Notice in the chart below that the Treasury rate tends to lead the Fed Funds rate.
Let’s home into the recent past. The following chart compares the two rates going back to 2013. Notice that when the YTM on 1- year Treasuries (red line) is above the target Fed Funds rate, the Fed tends to raise the Fed Funds rate (blue line). When the YTM on 1- year Treasuries is below the target Fed Funds rate, the Fed tends to lower the Fed Funds rate.
Given this perspective, we think the Fed will increase the Fed Funds rate 1 more time by 25 basis points. After that, we believe the Fed will be on hold. How the economy is performing in in three months is in question. The consensus is that economic growth will slow to a trickle, and the price inflation rates will continue to fall. This is what we think the market has priced in to the money and bond markets. However, we believe the economy will be stronger than the consensus view. At the same time, we believe the price inflation rate will decrease more slowly than the consensus expectation. Frankly, we are surprised at how fast the reported numbers are falling already. The Fed bought about $6 trillion in government securities in the last 3 years.
How investors respond to tomorrow’s announcement has little to do with the rate change. A 25 basis point increase will not surprise or concern anyone as everyone expects it. The price of equities will rise or fall depending on what the Fed’s prognosis for the economy, employment and inflation will be going forward. If they expect inflation to remain sticky, then equity and bond prices are likely to sell off.
All that said, we think people are missing a potential black swan. We believe the war in Ukraine is escalating as the US and Nato are now sending tanks to the Ukranina government. Just a few months ago, the president said the US government would not do that as it would be an act of war. Secondly, Isreal attached Iran over the weekend. They say that it was about the potential for developing nuclear weapons. Maybe so, buy maybe the US ally was sending a signal that Iran should not try to help Ukraine. We are in the dark on this as we only know what we read in the mains stream press. That said, it seems like the war is getting hotter. We are hoping we are wrong.
