The Federal Open Market Committee (FOMC) is set to release its policy rate decision today at 2:00PM EST. The broad market consensus is the Federal Reserve (Fed) will raise the federal funds rate by 25 basis points (bps) this afternoon. However, market participants will also be anticipating the release of the “dot plot,” which FOMC members use to signal their outlook for the number and timing of future policy rate increases. The dot plot was last released at the December 2016 meeting, and the median dots showed three 25 bps rate hikes for 2017. Although the dots can help investors understand what FOMC members are thinking, the dot plot can differ from the market’s forecast of future short rates in the Eurodollar futures market. Eurodollar futures contract prices are determined by the market’s forecast of 3-month USD LIBOR (3mL) at the contract’s settlement date. At the time of the December 2016 FOMC meeting, 3mL was 0.97% and the price of the EDZ7 futures contract was 98.43, meaning the market’s forecast for 3mL was 1.57% (100-98.43) at the contract’s December 2017 settlement – an increase of 60 bps.
Today’s chart shows the Eurodollar market’s forecast of 3mL since the Fed’s rate hike in December 2015. Back then the dot plot median projected four 25 bps hikes in 2016 and another four in 2017. Eurodollar futures, however, were pricing 55-60 bps increases in 3mL for each of the next two years – markets and the FOMC members were not in agreement. By the end of 2016, the Fed ended up raising rates only once and 3mL increased 40 bps. The Eurodollar market’s forecast for short rates was more accurate.
In December 2015, 10-year U.S. Treasury breakeven inflation was 1.5%, average hourly earnings (AHE) were 2.3% year-over-year, unemployment was 5.0% and oil was at $37/barrel and falling. Today, breakeven inflation is 2.0%, AHE is 2.8%, unemployment is 4.7% and oil is at $48/barrel. Today’s market appears much more willing to embrace a Fed hiking cycle than they were at the end of 2015. Risk assets took the December 2016 rate hike in stride and didn’t flinch when the likelihood of a March 2017 hike rose from 50% to 95% during the first three days this month. FOMC members, whether deliberate or not, have the markets well-prepared for this afternoon’s anticipated rate hike.Key Takeaway:
In all likelihood, the Fed will take advantage of market expectations and raise rates 25 bps this afternoon. This will come as little surprise to the markets. What may surprise the markets, however, would be anything in the new dot plot that signals a significant change in the number and/or timing of future rate hikes. Even if the dot plot changes significantly, keep an eye on the Eurodollar futures market. Recent history has shown that future rate hikes may align closer with the market’s forecast for short rates rather than the Fed’s dots.
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