WASHINGTON • Circle Jan 31, 2018, on the calendar. That is the soonest the Federal Reserve next raises interest rates. At least if money market derivatives are to be believed.
Traders, who have consistently been better at projecting the path of interest rates than the Fed itself, are now pricing in a greater probability that the US central bank will cut rates in upcoming meetings than raise them.
They do not assign more than a 50 per cent chance of an increase until the beginning of 2018, and do not price in a full rate hike until the final quarter of the year.
The sea change in outlook comes after global equities and commodities plunged while government bonds and the US dollar surged following Britain's vote to quit the European Union.
That has tightened financial conditions in the world's largest economy, driven down inflation expectations and dimmed the outlook for global growth.
"The market is pricing in a non- trivial probability of a Fed rate cut over the next couple of months," said fixed-income strategist Aaron Kohli at BMO Capital Markets, one of 23 primary dealers that trade with the central bank.
"The Fed is really boxed in now, so the market doesn't even begin to price in any real chance of hikes until mid-2017."
The market's view on the path of Fed policy is hardly set in stone. Rate hike expectations were upended in August and February amid similar bouts of market volatility.
Yet implied yields on federal funds futures, which settle upon expiration at the average effective fed-funds rate during the contract month, are pricing in a real chance of a rate cut by year end. The effective rate was 0.41 per cent last Monday, and is foreseen by traders averaging 0.35 per cent in December.
Options on euro-dollar futures, the world's most actively traded money market derivative, imply a 25 per cent chance of a rate cut by September. That is a reversal from just two months ago, when prices signalled that a rate hike by the end of the year was a virtual certainty.
If the market's dour outlook were to pan out, it would be like in 1998, when an Alan Greenspan-led Fed began cutting rates in September in response to market turmoil, before resuming hikes in June.
"The idea that they are more likely to cut than tighten in the next month or two... makes sense given the backdrop, but I think as you go out, it starts shifting back the other way," said chief US economist Jim O'Sullivan at High Frequency Economics. "Obviously there is uncertainty about how much fallout there is from Brexit - are we out of the woods on that yet, or do the markets continue to tumble?"
Fed chairman Janet Yellen cancelled plans to attend the European Central Bank's forum in Portugal this week to return to Washington, a sign that US policymakers are on high alert amid financial market turmoil following Brexit.
The Fed on Friday said it was prepared to provide dollar liquidity through its existing swap lines with central banks to avert undue stress on global funding markets.
Treasury yields have fallen in part due to safe-haven demand for US assets. Benchmark 10-year Treasuries pay just 1.47 per cent, near the all-time low of 1.379 per cent reached in July 2012.
BLOOMBERG
