The Fed vs the Forward Curve

Ahead of next week’s Fed rate announcement, Moritz Sterzinger examines US interest rate expectations.

I'd like to share a few facts about USD interest rates. On 10 June, the US Federal Reserve’s funds rate's upper bound was 2.5%, $1 million Libor fixed at 2.41%, and the five-year USD swap rate traded at 1.92%.

Consider the above numbers against the fact that, as recently as November last year, the five-year swap rates stood at circa 3.2%. In other words, the market expected at least two further rate hikes over the course of 2019. 

Things changed in the last quarter of 2018, when equity indices fell and high-yield spreads increased.

In response to these market jitters, as well as a softening global economy, the Fed turned markedly dovish, saying that it would put further rate hikes on hold for the time being. As a result, swap rates started dropping, first to 2.6% at the end of 2018, and then to 2.2% over the subsequent three months.

Since the Fed left its funds rate unchanged throughout this period, the result was an inverted yield curve – meaning that market participants were pricing in a rate cut.

So goes the story for the first quarter of 2019, but what is remarkable, and slightly worrying, is that interest rate expectations are now more pessimistic.

Today, the five-year swap rate stands at 1.92%. Rates markets now anticipate two rate cuts by the Fed over the next 12 months, suggesting that the US economy will experience a significant slowdown.

This is by no means an isolated occurrence: expectations for GBP and EUR interest rates have also fallen. And yet, unlike in Q4 2018, equities and high-yield spreads have held up during the most recent correction in swap rates.

Consider the XOVER high-yield index: it spiked to 373bps at the end of last year, but has since retraced to 279 again (the low being in the 220 area). This apparent divergence between rates markets signalling trouble ahead on the one hand, and equities and other risk assets being stubbornly resilient on the other, led some people to ask whether the former is “smarter”.

Maybe, but it seems equally likely that markets are once again underestimating how “hawkish” the Fed can be in the absence of any immediate macroeconomic pressures that might call for a rate cut.

Looking back over the past three and a half years to December 2015, when the Fed started normalising interest rates, the rates market made pretty accurate predictions about the near-term trajectory for short-term interest rates (see chart below).

However, a look at forward curves for December 2015, 2016 and 2017 reveals a consistent underestimation of the pace at which the Fed would raise rates to 2% and above.

Fed funds rate history and forward curves

A graph showing Fed funds rate history and forward curves


In other words, there have been plenty of instances in recent years where markets have had a more pessimistic view than the Fed regarding the level of short-term interest rates that could be supported by the US economy. It could well be that we find ourselves in one of these moments today.

We might know a little more after next week’s Fed rate announcement. As financial risk advisers, we think about possibilities and our clients’ objectives.

Most of those who are currently looking at hedging USD risk will have budgeted interest rates well north of 2%. For them, hedging interest rate risk has gotten a lot cheaper. Unfortunately, economic risk might have mounted as well.

Moritz Sterzinger is director at JCRA.

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