Rate Hikes Debate Creates Chasm Between Fed, Mr. Market’s Expectations

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When the Fed started raising rates late last year, investors were shocked when the plan that was unveiled indicated four rate hikes of 25 basis points each for this year. The markets were only pricing in half of that, so they shuttered on the news, which reverberated through global markets.

However, this gap between what U.S. policymakers are planning to do and what the markets expect has widened since then, with CreditSights and others predicting fewer hikes. The result could be a very rude awakening for Mr. Market.

Expectations for rate hikes evaporating?

Gluskin Sheff Chief Economist and Strategist David Rosenberg said in his Feb. 12 “Breakfast with Dave” note that as the markets were thrown into an uproar at the turn of the year, expectations for this year’s rate hikes just fell right off. Further, he says the markets are now no longer pricing in any hikes for this year—which runs directly counter to what the Federal Open Market Committee said late last year when they raised rates the first time.

He estimates that about 1.7 basis points of quantitative easing are currently being priced in, adding that markets set a 9% probability of a rate cut by the end of this year, compared to only a 2.4% probability of a hike, based on index swaps from overnight Thursday.

Gold and bonds flying high

Rosenberg said that because of how the markets have flip-flopped and now see a rate cut as being more likely than a hike, gold and bonds have been driven higher and are now the two best-performing asset classes. He notes that 10-year Treasury yields fell under 1.6% versus the interest rate repricing, causing a 7% year to date total return, while gold leads the way with a 17% year to date return.

Meanwhile the U.S. dollar is finally starting to reverse course, with the DXY dollar index now down by more than 3% for the year. Of course gold is priced in dollars, so this metric is key. And as rates decline sharply, the economist said there’s a “lower opportunity cost of holding the safe haven asset.”

The risks of the widening gap

So if Mr. Market doesn’t get his expectations in line with what policymakers are planning, things could get much worse. Rosenberg warns:

“If the Fed sticks to the policy tightening plan without market expectations appropriately weighting such a move, it would result in a sharp repricing of interest rates that would only serve to exacerbate this tightening of domestic financial conditions and intensify the headwinds for the economy.

He adds that basically what’s happening is that the markets aren’t buying what policymakers are saying anymore because they repeatedly moved back their plan to hike rates. And if policymakers can’t convince Mr. Market that they’re really going to do what they say they’re going to do, he sees the risk of a “potentially destabilizing rate shock.”

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