Edward J. Leach, CFP®, MBA
The Federal Reserve held their March meeting this past week and indicated no more interest rate hikes will be coming in 2019 as a result of concerns over slower growth and the potential for a bump in the unemployment rate. This is a significant shift from three months ago when the Federal Reserve announced two interest rate hikes would be appropriate for 2019.
Rising rates or reducing rates – why does it matter and what does it mean?
Keeping it simple:
When the Federal Reserve raises interest rates think of it as trying to put the brakes on the economy before it goes over the speed limit and crashes.
When the Federal Reserve reduces interest rates think of it as an attempt to shock some life back into a slowing economy.
The Federal Reserve has a tough job, almost an impossible job to do with 100% certainty and accuracy because they rely on forecasts. If anyone follows the weather – you know how forecasts can turn out. Forecasts are an imperfect science and, in reality, “best guesses” based on data that could turn out to be accurate or misleading.
The market, being as efficient as it is, prices this new information very quickly and can pivot on a dime. For example, the CME Group updates daily what the options and futures markets are pricing in for the probability of future rate hikes or rate reductions. It is essentially a “best guess” based on an interpretation of a “best guess”. Sounds irresponsible, but the reality is this is all we as investors collectively have to go on.
The next couple of charts, data courtesy of CME Group, show the probability “best guess” of what the target rate will be after the July 2019 and January 2020 meeting. Currently target rates are 2.25-2.5%.
According to the data, in July of 2019 the probability of rates being unchanged is 73% with the remaining 27% projecting a potential rate reduction. A rate reduction would mean the Federal Reserve is trying to spark a slowing economy. Complete opposite of what we heard in December regarding two more rate hikes. Interestingly enough, just last month the probability of rates remaining unchanged was 94.7%.
Looking at January 2020 the probabilities are far less certain. There is a 33% chance of rates staying the same and a 67% chance of lower rates. Only a month ago there was a 79% probability of rates remaining unchanged. This represents a significant shift in expectations and introduces a high degree of uncertainty as the Fed navigates potentially choppy waters.
What shouldn’t be surprising is how less certain the probabilities look for an event 9 months from now versus July, which is only 3 months away. It is like asking a meteorologist in January to project when and where severe storms will hit during hurricane season that year. There will be models and forecasts they can show you, but they are likely wrong because there is too much uncertainty.
This data is one of the pieces of information we monitor as an Investment Policy Committee. It won’t give us clear answers, but it does help in making prudent investment and planning decisions. Most importantly it is an objective way to see the markets.
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After hearing the Fed telegraph two potential rate hikes in 2019 back at the end of last year now the market is pricing a high probability we see lower rates by early 2020. Whether that comes to fruition – take your best guess.