Investors have tended to underestimate the scale of future rate hikes from the Federal Reserve in the past, and it is highly likely that they are making the same mistake again claims Capital Economics.
According to the research outfit, in the past three tightening cycles the market has significantly underestimated the rate of change in the fed funds rate with the Fed increasing rates at a rate of almost double what the market was expecting during the 1994 to 1995 and 1999 to 2000 tightening cycles. In the last tightening cycle, 2004 to 2005 the Fed tightened only slightly faster than the market expected, but still caught traders and analysts off guard.
Are investors underestimating the scale of future interest rate hikes?
The team over at Capital Economics believes that there will be at least one 25bps rate hike in the US this year, putting them at odds with the rest of Wall Street.
According to Bloomberg, at the beginning of June implied yields on federal funds futures, which settle upon expiration at the average effective fed-funds rate during the contract month, were pricing in a possibility of a rate cut by the end of 2016 and no further hikes until the beginning of 2018 at the earliest.
At the end of June Fortune also reported that traders were assigning a 10% probability of the Fed cutting interest rates at its July meeting and a more than 20% chance of a rate cut at subsequent meetings later in the year and in early 2017.
Analysts at Morgan Stanley hold a similar view. The bank’s chief cross-asset strategist Andrew Sheets doesn’t expect the Fed to hike rates until 2018 as he believes global growth will really disappoint over the next 12 months and the Fed will need to remain accommodative during this period.
Considering Capital Economics’ data, which shows that the vast majority of analysts tend to underestimate the pace of US rate hikes, it’s entirely possible that the general market consensus may be too pessimistic on rates.
Only time will tell which set of analysts is the most adept at forecasting, but we should be able to learn more about the Fed’s intentions later today when officials at the central bank conclude a two-day policy meeting on Wednesday afternoon. While no monetary policy moves are expected, its statement will be watched closely for clues to future action.
Capital Economics is predicting a rate increase of 25bps this year and then a steady pace of rate increases through 2017 which will take the Fed Funds Rate to around 1.75% by the end of 2017. By the end of 2018, the team at Capital Economics expects the Fed to have increased rates to just under 2.75%. Fed Funds Futures are implying a rate of 0.8% by the end of 2018; the FOMC median projections are suggesting a rate of 2.25%.