Market’s Under-pricing Chance of New Federal Reserve Rate Hikes

In the run up to Wednesday's FOMC, markets have drastically lowered the probabilities of a Fed rate hike - but some analysts believe it is wrong to turn dovish.

According to market-based indicators of when and by how much the Federal Reserve is likely to change rates there is now a negligible chance of a rate hike this Wednesday, only a 25% chance of a rate hike in March and only 25 basis points of rises priced in for the whole of 2016! 

In a recent note Barclay's clarify the market's position: 

"Fed fund futures assign only a 25% chance of a hike in the March meeting while for the whole year only 25bp are priced in."

BMO Capital Market’s FX Weekly neatly encapsulates the market view of the January meeting, saying they expect the Fed’s meeting statement to remain largely unchanged:

“We don’t expect much from the FOMC meeting on Wednesday.

“The few FOMC participants who have commented on 2016 have said that the economic outlook remains largely the same as it was in December.

“We assume this is the message that will be reiterated in the FOMC’s Statement on Wednesday.

“BMO’s economists expect very little in terms of language changes.

“This is not a meeting with a press conference or updates to economic projections.”

Markets Wrong

Analysts at Barclays, however, do not share the prevailing view that the probabilities of a hike have greatly reduced.

In a recent note, they argue, that as a consequence of this misrepresentation markets are “under-pricing” the “Fed’s normalization cycle.”

If Barclays are right and markets are under-pricing the chances of the Fed tightening further, then the FOMC may set markets straight again, and prices will change as a consequence.

This would indicate that if the Fed’s rhetoric fails to back up the market’s current dovish skew there is scope for the dollar to appreciate.  

It’s not just Barclays who see market’s as adopting an overly dovish skew, Halo Financial, also see the same risk, and therefore the possibility of a dollar rally following the Fed’s statement:

“US data has been mostly positive of late so they may well remind markets that they are still expecting to raise rates 3 or 4 times in 2016.

“Currently the market is not pricing this in so a more hawkish FOMC will certainly see the dollar strengthen.”

292k Payrolls Forgotten?

Meanwhile ASB Bank note how positive labour market data has been recently and how this could feed into a more hawkish upbeat view from Fed member’s:

“The FOMC should retain its upbeat view of prospects for the US economy, particularly the labour market in light of the recent strength in the US labour market data.”

Indeed, the last payrolls report at the start of January showed a much higher-than-expected result of 292k from the 200k consensus.

At the time forecasters saw the likelihood of the Fed adopting a hawkish tone at the next meeting as pretty much a ‘done deal’; take DailyFX’s David Song, who I quoted at length in early January, following the Payroll’s release:

“Despite the cautious tone laid out in the (December) Fed Minutes, a further improvement in labour market conditions may encourage the committee to adopt a more hawkish tone at the January 27 interest rate decision as Chair Janet Yellen remains confident in achieving the 2% inflation goal over the policy horizon.”

A symptom of how far hawkish expectations have fallen in the last few weeks, comes from a reminder of how market-watchers at the start of January were asking whether there would be a January rate hike – not whether there would be a March hike.

Davos Consensus China-Fears Overdone

Indeed, as I said in the report on January’s Payroll’s release, one offsetting factor which might prevent the FOMC from raising rates, was the possibility of more China-hard-landing fears.

Whilst this was a concern in previous weeks, the situation now seems to have settled down, and, according to a note from SEB Bank, the financial elite are saying that if anything China concerns have been overdone:

“The World Economic Forum in Davos ended on Saturday and even though there is no official summary one conclusion seems to be that market concerns for a crash in China are overdone.

“We are not seeing a hard landing in China” according to IMF head Christine Lagarde.”

However, the report adds the proviso that the governor of the Bank of Japan was obviously still concerned enough about Yuan risks to encourage China to tighten capital controls say:

“Still, BOJ governor Kuroda wants China to impose tighter currency controls in order to stop the Yuan outflows and stabilize the currency.”

Nevertheless, assuming markets have over-exaggerated China risks, this would also indicate the possibility that FOMC might take a more hawkish line than currently expected.

Composition of Fed in 2016

One final detail missing from many of the reports about the FOMC is that every year they rotate their voting members and at the January meeting it will be the first time that the new 2016 member’s will be eligible to vote.

This year sees Lockhart and Lacker replaced by the more hawkish Bullard, Mester, George and Rosengren, which could be a further factor increasing the odds of a retrenchment and increased risks the meeting might lead to a readjustment of the current dovish stance and more upside.