From early 2014 through 2018, expectations for rate hikes by the Federal Reserve (Fed) moved almost in lockstep with U.S. equity markets. Higher stock prices eventually translated into expectations that the Fed would hike rates while lower equities would cause (or at least coincide) with fixed-income investors backing off rate-hike expectations. Since the beginning of 2019, however, a yawning gap has developed between what equity investors and fixed-income investors expect (Figure 1).
Between the day after Christmas and the first full day of spring this year, the S&P 500® rose over 21%. Much of gains was stoked by expectations that the Fed would hold off on rate hikes following the Q4 2018 equity selloff. But now that the Fed is on hold, fixed-income investors are changing their opinions once again: merely unchanged rates is no longer enough to support stocks. Increasingly, Fed funds futures are calling for outright rate cuts – and frequently, with the Fed seen cutting rates 2-3 times between now and the end of 2020 (Figure 2). Yet, the Fed’s recent dot plot and statements didn’t contain even the slightest hint that anyone on the policy-making Federal Open Markets Committee (FOMC) thinks that the central bank will be cutting rates between now and the first quarter of 2021. Even so, the major U.S. equity indices are within a few percent of their record highs at the time of this writing – although they seem to be losing momentum.
This disparity between U.S. equities and rate expectations is likely to get resolved in one of three ways:
The last possibility seems like a fantasy. The Fed probably won’t cut rates until it is put under duress by a sharp downward move in stocks. Doing so would be tantamount to admitting that it overtightened, and who likes to admit a mistake? As such, it seems much more likely that either equities will continue to rally and pull Fed funds futures higher (in rate terms, so lower in price terms); or unfulfilled expectations of a Fed rate cut will cause equity investors to begin selling shares, bringing stocks in line with increasingly bearish rate expectations. Any such selloff might continue until the Fed short-circuits it by easing policy.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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