Currently, investors appear to be covering their eyes, ears, and mouths and ignoring the Federal Reserve's (Fed) determination to increase interest rates. This divergence of outlooks between investors and the Fed is a stark departure from the financial crisis and the years following when the Fed and the market were on the same page regarding monetary policy.
Often such a discrepancy between the Fed and investors results in sharp changes in asset prices and heightened volatility. In this article, we analyze the current situation to predict whether the market's dovish expectations will be proven right, or if their unwillingness to heed the Fed's warnings will cost them dearly.
Trump vs. Powell
As we were putting the final touches on this article, President Trump sent a clear shot across the bow of the Fed and in particular Chairman Powell. His message to Powell was simple: stop raising rates. As you read this article consider the position that Powell and the Fed are now in. If Powell walks back his hawkish stance, regardless of why, it will be regarded as acquiescing to the President's request. On the other hand, if he ignores the President and continues to raise rates, we might see his tenure at the Fed limited. Either way the Fed's independence is likely to be tested.
Starting in 2017, the Fed took a decidedly more hawkish stance than the market was expecting. Whether this was a result of President Trump's pro-growth campaign promises or greater confidence in economic growth and renewed inflationary pressures, we are not certain. We do know that the difference between the market's expectations and the Fed's plans has persisted to this day, despite the Fed raising interest rates five times over the past couple years and reducing their balance in increasingly larger amounts as they've said they would.
The following graphs demonstrate the prior and future divergent views. The first graph compares expectations (using fed funds futures) for the fed funds rate nine months forward versus the prevailing fed funds rate nine months later. The current reading of -0.40% denotes that Fed Funds futures were priced for a Fed Funds rate of 1.60% nine months ago while the fed funds rate is close to 2% currently.