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Traders slash expectations for how high Fed will increase rates

US interest rates updates

Traders have dramatically scaled back their expectations for how much the Federal Reserve will increase interest rates in the years ahead, as a murkier economic outlook and fears of a peak in economic expansion raise doubts over the path of monetary policy.

Prices of eurodollar futures, which are used by traders to bet on the direction of interest rates in the months ahead, have rallied sharply over the past three months in a sign of changing views. As those prices have risen, the rates on eurodollar futures, which move in an inverse direction, have fallen.

The price action indicates that traders believe US rates will rise much less than they did in April or May, when strong inflation pressures had money managers girding for what they believed could be an aggressive response from the Fed.

But even as inflation figures have continued to hit new highs — consumer prices were up 5.4 per cent in June from the same period a year ago — the increases have been accompanied by a fear that the impressive economic rebound will eventually fade. That could test just how high policymakers in Washington ultimately raise interest rates.

While investors continue to believe the Fed will first tighten rates from the current rate around zero in late 2022, implied rates in December 2023 have fallen to 0.69 per cent. That is down from 0.81 per cent in mid-May and 0.94 per cent at the start of April.

Further out, expectations have drifted even lower. US interest rates look set to rise only to 1.46 per cent by December 2026, almost a full percentage point lower than the 2.32 per cent traders had priced in April, eurodollar trading shows.

“The market is saying, ‘we think a hiking cycle will start but we’re not big believers it will be a full-on rate hiking cycle. Inflation won’t be persistent enough for it’,” said Jason Williams, a strategist with Citigroup.

Shifting interest rate expectations have filtered into other markets, with a swift rotation under way in the $49tn US equity market as well as a drop in long-term Treasury yields. The yield on the 10-year note fell as low as 1.13 per cent last week, the lowest level since February, before increasing.

Despite a less dovish tone from the US central bank following its June meeting, at which Fed policymakers projected that rates could begin rising in 2023 and over the long run could reach 2.5 per cent, investors have called into question the strength of the global economic recovery. Investors have pointed to signs of a slowdown in China, as well as weakening consumer confidence figures in the US.

The slide in Treasury yields has for some money managers been a confirmation that growth will fade. It is a reason why Ian Lyngen, a strategist at BMO Capital Markets, believes the Fed will attempt to strike a more dovish view during its next meeting.

“The global headwinds represented by the Delta variant haven’t risen to a level warranting a rethink of tapering,” Lyngen said, referring to the Fed’s eventual wind-down of its asset purchase programme. “Instead, the path toward the lift-off increase has become even longer along with the progress out of the pandemic.”

Over the past two months, investors have cut bets on companies that were expected to benefit the most from an accelerating economic rebound and the country’s reopening, including shares of small-cap stocks and economic bellwethers such as railroads and shipping groups. Instead, they have returned to one of their favoured trades of the past decade: Big Tech.

That is in part because money managers believe faster-growing businesses, including those unprofitable groups whose valuations are dependent on earnings far in the future, will at least continue to expand at a brisk pace if the broader economic rebound decelerates.

“We live in a world where every asset class, whether bonds, real estate, equities and others are all underpinned by low interest rates,” said Pramod Atluri, a portfolio manager at Capital Group. “Thus anything that impacts the trajectory of those interest rates — how low they’ll be and for how long — could have a dramatic impact on every corner of the financial market.”

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