US: Markets offering the Fed a free lunch - Rabobank

Philip Marey, Senior US Strategist at Rabobank, explains that in just a few days, Fed speakers have prepared the markets for a March rate hike as a week ago the probability implied by the fed funds futures was only 40%, but now it had risen to 90% without causing any market panic which means that the markets were essentially offering the Fed a free lunch: the Fed does not have to worry about a major adverse market reaction in response to a hike.

Key Quotes

“In fact, for many in the markets the Fed’s hiking plans are seen as a stamp of approval for the Trump rally. Chair Yellen said that at the FOMC meeting later this month, the Committee will evaluate whether employment and inflation are continuing to evolve in line with expectations, in which case a further adjustment of the federal funds rate would likely be appropriate. Shortly before her speech, the implied probability of a March hike stood at 88%, afterward it had risen to 96%.”

“Animal spirits

The Fed’s urge to hike only three months after the December hike, being very hesitant only a month ago at a meeting that revealed a lot of uncertainty regarding the fiscal policy plans of the new administration and its impact on the economy, suggests that the Fed is now making the same bet on fiscal policy as the markets. So the ‘animal spirits’ that have lifted the markets have penetrated the walls of the Fed as well. If we are right in our assessment that the market rally is overdone and that it will be difficult for President Trump to deliver on his promises, then the Fed joining the party could make the bubble even more dangerous, ending in an even larger reversal.”

“What could prevent a March hike?

Note that in June 2016 markets had been prepared for a hike by the FOMC as well, but then one bad Employment Report only shortly before the meeting derailed that plan. This could happen again this month, as the next Employment Report will be published on March 10, only a few days before the FOMC meeting on March 14-15. Another scenario is a severe market correction to the Trump rally in the first half of March. This would call into question the Fed’s upbeat assessment of the markets and the economic outlook, and revoke the market’s invitation for a free lunch that Yellen so eagerly accepted.”