US markets still divided over rate cut or not this year

There is little conviction about the baseline, with the market tilting toward rate cuts but not entirely convinced. Given how low rates already are, the curve looks rich to us.
Duncan Tan28 May 2019
  • Idea of markets expecting 2-3 Fed cuts is taken primarily from Fed Funds or Eurodollar futures
  • Futures prices are markets' probability-weighted expectation of the range of possible Fed outcomes
  • Professional forecasters see an on-hold Fed as the most likely outcome
  • Eurodollar options markets are somewhat divided
  • The options-implied probability distribution is more spread out for 2020
Photo credit: AFP Photo

US Rates: Will the Fed cut or not cut?

The prevalent idea of markets expecting 2-3 cuts by end-2020 is primarily taken from Fed Funds or Eurodollar futures. At present, Fed Funds futures prices are implying that the future rates at end-2019 and end-2020 would be below current rate by 31bps and 65bps respectively. Fundamentally, these implied future rates do not reflect markets' base case (i.e. most likely outcome as seen by markets).What they really represent, are markets' probability-weighted expectations of the entire range of possible Fed outcomes.

In Bloomberg's survey of professional forecasters, as of May 9th, 77% of forecasters expect the Fed Funds target range to be unchanged at 2.25-2.50% come end-2019. For end-2020, a lower proportion of 38%, but still a majority, expect so. The professional forecasters, therefore, are far more sanguine about the outlook than their counterparts in the markets

The Eurodollar options market, by offering a range of strikes, would best provide a granular view of market expectations. From option prices, markets’ interpretation of the probabilities of various possible Fed outcomes at different points in time can be backed out. The end-2019 and end-2020 implied probability distributions shows that markets' base case is for the Fed to stay on hold (2.25-2.50% target range holds the highest probability). Notably, both distributions are skewed to lower rate ranges (left tails are longer).Markets seem to think Fed rates, if they decline, could be by a lot. On the other hand, any rise in rates is likely to be capped. Interestingly, the end-2019 distribution is much less symmetric compared to end-2020 distribution.Markets are assigning much higher probabilities to cut scenarios than hike scenarios in 2019.

Considering that Eurodollar futures are the underlyings for Eurodollar options, it is safe to assume that the futures markets are pricing in very similar set of probabilities.Market expectations appear to be quite appropriategiven the current Fed outlook. With US economic momentum still strong and inflation weakness “transitory” per Fed, the hurdle for the Fed to shift from a “patient” stance to signalling hikes or cuts is probably high. However, slowing global growth and more protracted than expected trade wars likely mean risks are asymmetric, skewing towards cut scenarios.

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Duncan Tan

FX and Rates Strategist - Asean

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