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Fed Funds Futures Market Begins to Flirt with the Possibility of a Rate Hike

The monetary policy outlook has been uncertain, particularly as to when the first rate cut would occur. But that is starting to change as Fed funds futures are pricing in the possibility of a rate hike. To be clear, the implied probability of a hike is extremely low: no more than 1%. But the fact that market sentiment is pricing in any possibility of a hike marks a shift.

It is questionable whether this shift is significant or just market noise. As for the central bank, Fed policymakers have communicated in recent months that rate hikes are unlikely, while remaining tight-lipped about the timing of rate cuts. Fed funds futures still do not signal a contradiction to this forecast – the priced-in probabilities still mostly lean toward no change or rate cut for the next FOMC meetings. For example, according to CME data, the market estimates a probability of around 50% for a rate cut at the September 18 FOMC meeting.

The policy-sensitive 2-year Treasury yield also factors in a lower Fed target rate, currently at 5.25% to 5.50%. In contrast, the 2-year bond traded modestly lower at 4.91% yesterday (May 23). To be fair, the 2-year rate has been waiting for a rate cut for over a year. In any case, this widely followed rate suggests that the crowd is still leaning toward rate cuts rather than hikes at the next policy change.

However, in recent days, economic data suggests that the economy remains robust, suggesting that it is premature to rule out the possibility of a rate cut. In particular, PMI survey data for May suggest that the US economy has recovered significantly after April’s weakness. At the same time, interest rates remain low, meaning that the labor market will continue to grow at a healthy pace in the near future.

The key variable is the trajectory of inflation. The latest numbers show renewed signs of progress in disinflation, but the latest Fed reminder that while rate hikes are still very unlikely, the possibility is present in the minds of policymakers, or at least that’s what it seems like when reading between the lines of the recent review of the May 30-April 1 FOMC meeting:

Participants remained very aware of inflation risks and pointed to the uncertainty surrounding the economic outlook. Although monetary policy was seen as restrictive, many participants expressed uncertainty about the extent of this restriction.

Participants considered that this uncertainty was due to the possibility that high interest rates might have less impact than in the past, that longer-term equilibrium interest rates might be higher than previously assumed, or that potential output might be lower than estimated. However, participants assessed that monetary policy remained well placed to respond to changing economic conditions and risks to the outlook.

The idea of ​​a rate hike is heard subtly in the minutes, and commentary overall still leans heavily toward do nothing at best – which is in line with Fed funds futures. But the fact that Fed officials and futures are beginning to explore the possibility of further tightening adds a new risk factor, however small, that must be considered for the macro outlook.

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