Markets and the Federal Reserve Finally Agree on Something

Hopes of fiscal expansion under President-elect Donald Trump and improvements in the U.S. economy have combined to achieve the near-impossible: financial markets and the Federal Reserve are now singing in unison on the near-term outlook for the central bank's policy rate.

"The market and FOMC head into 2017 with similar views on rates for the first time in years," writes Neil Dutta, head of U.S. Economics at Renaissance Macro Research.

Overnight index swaps imply that the federal funds rate will end 2017 at 1.07% as of 11:30 a.m. ET, which would mean the two hikes in 2017 that the median Fed official is anticipating, plus one in December of this year, based on the dot plot would come to pass.

Dutta cited the firming U.S. Markit Composite PMI, rising core capital goods shipments, robust consumer confidence, and accommodative financial conditions as pointing to strong growth ahead. Indeed, the Atlanta Fed's GDP Nowcast for growth in the fourth quarter stands at 3.6% as of Nov. 23.

Traders had previously come to see the Fed as the 'Central Bank Who Cried Rate Hikes' — and with good reason, as monetary policymakers have consistently overestimated how high the federal funds rate would rise over the short and medium-term.

In September 2013, the median Fed official saw its policy rate at 2% by the end of 2016 in the event that their economic forecasts were realized, which is about 140 basis points north of where it's currently expected to end the year.

The last time the market and Fed were roughly aligned at year-end on where policy rates would be 12 months down the road was at the end of 2013.

Dutta thinks there's a "growing chance" that in the first half of 2017, the market could anticipate a faster pace of tightening than the Fed is telegraphing, a reversal of what's been the long-standing trend.

"With accelerating wage and price inflation, there is a growing risk that the market sees the Fed as behind the curve, pushing longer-term rates higher," he writes. "The Fed tends to move much more slowly than the market. Indeed, some of the recent repricing is the result of policies that have yet to be announced or enacted."

Bloomberg News
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