With the Federal Reserve’s next two hikes mostly seen as a foregone conclusion, investors have turned their attention toward the prospects for next year’s increases.
Markets have gradually fallen in line with the central bank’s “dot plot,” a collection of senior Fed officials’ projections of where interest rates are headed. Though the dot plot indicates the Fed expects more two rates this year, and an additional three next year, Wall Street was reluctant to price in the last hikes of the current tightening cycle as escalating trade tensions and a nearly inverted yield curve had led investors to doubt the Fed’s ability to deliver on its forecasts.
“In previous hiking cycles, the market has underestimated the Fed. The market is going to underprice the Fed until the very last bit,” said Jason Celente, a senior portfolio manager at Insight Investment Management.
But markets started to catch up with the Fed in September. The price difference between the December 2019 eurodollar futures contract EDZ19, -0.01% and the December 2018 eurodollar contract EDZ18, -0.03% an indication of how many rate hikes money-market traders expect next year, jumped to 50 basis points, or two full hikes. Before this month, the spread between those two contracts bounced between 30 and 40 basis points, implying investors’ forecasts were split between one and two rate hikes in 2019.
BMO Capital Markets
Though investors traditionally glance at the fed fund futures market for Wall Street’s expectations for the central bank, some say futures for the eurodollars market, where dollar deposits are bought and sold by non-U.S. banks, is more liquid and therefore a more accurate indicator of where market participants anticipate the Fed to go.
The impetus for that repricing came from a higher-than-expected wages number from August’s jobs report, considered the missing ingredient for a sustained buildup of inflationary pressures.
“The near-term catalyst appears to have been the strong average hourly earnings data,” said Jon Hill, an interest-rates strategist at BMO Capital Markets.
In addition, U.S. central bankers have started to sound more hawkish. Chicago Fed President Charles Evans said his colleagues were singing from the same hymn sheet on the solid growth and inflation outlook, while Fed Gov. Lael Brainard, previously seen as on the dovish side, said she wanted to push rates above the neutral level into restrictive territory.
See: Trade war with China may limit Fed’s interest-rate hike plans after September increase
Expectations for further monetary tightening has lifted yields for U.S. government paper. The 10-year Treasury note yield TMUBMUSD10Y, -0.09% sits at 3.065%, within striking distance of its seven-year intraday high at 3.119%, according to Tradeweb data. The yield for the two-year note TMUBMUSD02Y, -0.14% which closely tracks the Fed’s benchmark interest rate, is at 2.808%, its highest since June 2008. Bond prices move in the opposite direction of yields.
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