Yellen’s Calendar Quandary

Making the Case for a Surprise Rate Hike

An article in Bloomberg caught my eye this weekend. The headline was “Bond Traders Give Fed Green Light to Lift Rates as Soon as June.” Accompanying the article were several interesting Bloomberg Professional® graphs and pages. For me, the following one really stood out.

bberg hike odds

The way to read the chart is to recognize that the body (right hand side) of the display is the bond market’s expectation, calculated from the price of Fed Funds interest rate futures and options over the coming year.

When the market says the odds of 0.50% to 0.75% drop to 50.4% for the June Fed meeting, it is saying that the odds for another rate hike on or before the June 15 meeting are 50/50. The market was so sure of its continued Fed monetary heroin and its own importance that just a month ago it was only pricing in a 10% chance that there would even be a second rate hike before the first half of this year was over.  That was just before this recent rally, which still might be a bear trap.

If we look out to the end of 2016, the market thinks that the most likely place for rates at that point is 0.50% to 0.75% (one more rate hike), with about equal odds that there will be none, or two. The odds for a total of four increases is only around 1 in 10 at that point.

So why do I think there might be a surprise in the works?

Look at the dates for the Fed meetings, and consider that Election day this year is November 8th, the week after the second-to-last meeting of the year. And the last meeting is on one of the lowest-volume days of the year, December 24th. That’s a date that simply can’t absorb any extra volume without becoming wildly volatile.

Now I come back to the basic reason the Fed is raising rates in the first place: to get them somewhat closer to normal before the next recession.

We’re seven years into the recovery from the meltdown-induced Great Recession, so there’s basically not enough time left to raise rates to a ‘normal’ 2% to 3% range. Still, their language prior to beginning the process made it very clear they were trying to move rates while they could. Before the rate-hiking process began, the hints were not too subtle that the Fed hoped to execute a gradual increase to 1% followed by an extended pause to see how much the system normalized.

What if the Fed Governors believe that “re-loading” their one reliable recession-fighting gun is more important than the pain inflicted by the junkies in the stock market who always want another hit? Let’s face it, the stock market has nearly tripled from the bottom of the recession, but Main Street has basically gotten nowhere. If Main Street needs their help, the Fed wants to be able to respond, and the sooner the Fed is ready, the better. Seven years without a recession is very rare, something we saw in the 90’s, but not before or since.

So start from the point of wanting at least four rate hikes before the next recession gets going, and work backward from there. We’ve already seen that December 24 and November 2 are probably really bad ideas. Even September 21 starts to sound like it’s too close to the election, given how extreme the political rancor is likely to be at that point in the year.

So that leaves this coming week, the meeting after that in the last week in April, the June 15 meeting, and a meeting near the end of July. How to spread them out? After all, if they raise rates two meetings in a row, that’s likely to scare the market worse than almost any other way to raise rates, short of jumping a full half point at once.

The one thing I’m pretty sure of is that Chair Yellen wants to have as many bullets in the rate cut magazine as possible before the next downturn. I suspect the Fed is also getting tired of having the stock market play its extortion game to keep the free money pumping.  They may be ready, in fact, to let the stock market have a healthy bear, so they have the tools they need for the real world, if needed.

So I’ll go out on limb here, and predict that we’ll see hikes in April and July, with another February 2 next year. I believe they are set on getting at least those four “bullets.” This gradual round of rate hikes will only be put off if indicators for the real economy are looking pretty bad. I actually think the Fed would rather do a hike this week, another in June, and then one for the Autumnal Equinox with plenty of warning so they get to their goal before 2017 begins and the markets have some time to digest before the election. That said, the stock and bond markets are very good at complaining, so they probably won’t get all four hikes in before the end of the year.

If the recession comes before then, all bets are off.

hh


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