The futures market was still expecting Fed rates to rise in 2019 from 2.4% on the date of inception to 2.44% at year-end. The rates market was pricing a less than 5% chance of a rate cut in 2019 and a 20% chance of a hike in by June.
FOMC policy tightening has been stable and predictable for the last two years, but now that the Fed has moved to a ‘wait-and-see’ mode, and has bought optionality around the pace of balance sheet reduction, uncertainty over the next step is high. We reckon Powell’s FOMC is more pragmatic than previous committees, and will be more willing to act against the risk of curve inversion. In our view, the US economy needs a rate cut given signs of a slowdown. And slowing the pace of QT makes it more likely.
Market expectations of Fed policy have stabilised after the wobble around the new year, when at one point the market was discounting over 10bp of rate cuts for 2019. And although the slightly upward-sloping curve includes a non-zero probability of rate cuts, according to Bloomberg, market expectations of a cut this year are less than 5%. The market discounts a 20% chance of a rate hike by June. We reckon the balance of risks is the other way around: either the Fed cuts rates this year or does nothing.
We expect that once the pace of QT is slowed, the market will move to discount a greater chance of rate cuts in future meetings. If the pace is slowed at the March meeting, this puts a timescale on discounting cuts starting in Q2. We expect the rate cut to come after it becomes evident that data has not improved – thanks to the government shutdown, this means the cut will most likely take place in Q3.
We buy the October fed funds future at 97.53 with a stop below 97.40: the current price reflects a market expectation that the fed funds rate will be 2.47% on average in October (it is currently 2.4%). We reckon October is the optimal entry point given our expected timing of the rate cut and the shape of the fed funds curve: the December price is a little higher than the October price. We reckon there is a better chance of it averaging 2.15%, equivalent to a futures level of 97.85.
We took profit of 27bp on 27 March as the contract hit our target of 97.80. By that time markets had completed a 180 degree U- turn in 3 months and were pricing an 80% chance of a Fed cut in 2019, and 60% by end of Q3.