History Warns The Fed Will Raise Interest Rates More, Not Less
“Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.”- Investors Are Grossly Underestimating the Fed
Our advice to plan for the unexpected was prescient. When we wrote the article in July 2019, Fed Funds were between 2.25% and 2.50%. The Fed Funds futures contracts were implying the Fed would reduce rates by .75% in the forthcoming months.
By April 2020, Fed Funds were trading near zero, 1.50% below where the market thought they would be in mid-2019. The article quantifies the Fed always raises or cuts rates much more than expected.
Today, the market is pricing in steady increases, starting in 2002, for the Fed Funds rate. Despite high inflation and low unemployment, the Fed refuses to even think about thinking about raising rates.
Given the Fed’s posture, it may appear traders are overestimating how much the Fed will raise rates. However, we caution once again; traders always underestimate the Fed.
Whether higher Fed Funds seems logical is irrelevant. As investors, we need to strategize in case history proves clairvoyant. Given the Fed is starting to normalize monetary policy, it’s worth revisiting the article from 2019.
We recommend reading the article’s first section linked above for more background on Fed Funds and their futures contracts.
The graph below shows how much the Fed Funds futures market consistently over or underestimates what the Fed does. The green areas and dotted lines quantify how much the market underestimates how much the Fed ultimately reduces rates…
…click on the above link to read the rest of the article…