Ahead of the Federal Reserve’s next decision on Wednesday, derivatives markets show the long-term federal-funds rate sitting at around 3.5%. This is a full percentage point higher than the central bank’s own latest forecast. Those bets have moved higher throughout the year, and are no longer close to the levels known as the “taper tantrum” since the bond-market rout of 2013.
A prolonged period of higher rates could propel the market, which has been rallying in recent weeks. Higher rates have penalized high-flying tech stocks this year, which enjoyed near-zero borrowing costs. A longer-term transition to higher rates could mean weaker valuations for the tech sector, as well as others where investors expect profits down the road.
The market effecting these interest-rate bets — the five-year, five-year overnight indexed swap rate — is used by market participants to either hedge interest rate risk or where the fed-funds rate will be higher than the five-year period beginning. It is determined by placing a bet on it. Over five years, it has remained a useful gauge for the future path of Fed policy.
The swap rate has risen below 1% in early 2020 to its highest level since 2014, near the end of investors’ multi-month bond-selling spree, following the central bank’s announcement that it would end the financial crisis- would withdraw from the bond-buying programs of the era. ,
The last time the Fed attempted to restart those efforts was in 2017, trouble in short-term lending markets forced officials to inject emergency cash just two years later. With the central bank now diving into another round of those efforts, traders are reneging on their bets.
Most investors expect Fed officials to raise the benchmark federal-funds rate by 0.75 percentage points at the central bank’s November meeting, the fourth consecutive increase of that size.
The yield on the 10-year Treasury has risen from just 1.6% in January to nearly 4%, helping drag the benchmark Bloomberg US Aggregate Bond Index down more than 15% on the year. The 10-year yield is up more than 1.4 percentage points since August, the biggest three-month gain since 1984.
Many investors continue to expect central banks to slow down their efforts to fight inflation. After the European Central Bank raised rates by 0.75 percent at its latest meeting – and many officials expressed a desire for a less aggressive move – the bond and futures markets quickly adjusted to the slow pace of tightening. However, many European countries stubbornly reported high inflation and policymakers pushed back against the idea that there was rest on the table.
Policy rate-linked futures contracts now show fed funds a peak of around 5% around May or June, and remain higher from there. Earlier in the year, traders centered around the idea that rates would peak in March, followed by significant rate cuts.
Nomura managing director Charlie McElligott said in a Monday note that a small rate hike from the Fed may not really mark a pivot in policy. The more significant change is “hiking is off the horizon,” he wrote.
Key drivers of the renewed tightening monetary policy expectations include the unusual strength of domestic finances, the stimulus driven by the pandemic. The historically heated labor market also fuels inflation through wage-raising. With little signs of economic or financial trouble, the Fed may have more room to run.
Brian Whelan, co-chief investment officer for fixed income at TCW, said, “If nothing is going to break through in the financial markets, it will take some time for the employment landscape to generate enough destruction to dampen consumer demand.”
A recent survey by the New York Fed showed that while Americans’ average inflation expectations for the next year continued to decline, long-term expectations rose to 2.9% for the next three years. The latest consumer survey from the University of Michigan showed similar expected price changes, but over the next five to 10 years.
Consumer-price index-linked swap contracts do not break headline inflation below 2.6% at any point in the next 30 years. Those bets have driven real inflation rates down significantly this year.
“Unless the Federal Reserve is ready to engineer a depression, we will have to deal with at least two to three more inflation [tightening] cycle,” said Thomas Tsitzoris, managing director and head of fixed income research at StrataGas. “The rate hike will crush economically sensitive cyclical inflation, but 3% to 4% headline inflation is structural.”