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Fed Funds Rates: Are quicker hikes on the Horizon?

Jun 26, 2018
Fed Funds Rates Are quicker hikes on the Horizon header

Background

The Federal Reserve raised interest rates by another 25 basis points to 2% on June 13th proving the pace and cadence of rate hikes is speeding up. Using hawkish and robust language when discussing the US economy, the Fed set expectations for 1-2 more rate hikes this year.

Although the Fed is coming off as aggressive, some market participants are skeptical of 2 interest rate hikes and argue that if the Fed is too aggressive, that could invert the yield curve and signal a recession. Furthermore, pundits claim, being even more aggressive with interest rate hikes would potentially slow economic growth in the U.S. and possibly cause the dollar to rally making exports more expensive.

On June 15th, the New York Fed Chief William Dudley stepped down from his post and stated: "The federal funds rate will probably have to climb a little bit above neutral because the unemployment rate is already -- from most people's vantage points -- below a sustainable level of unemployment consistent with stable inflation."

Expectations

As of Friday last week, 30 Day Federal Funds Futures implied a 40.4% probability of a rate between 2 and 2.25% and a 50.1% probability of a rate between 2.25% and 2.5% at December’s meeting. Two more rate hikes this year would move the fed funds rate between 2.25% and 2.5% and futures on Friday implied a 2.19% fund rate by December.

Chart - Target Rate Probabilities
Digital Transformation & Inflation

In the past 12 months, the Consumer Price Index (CPI), a measure of inflation, has risen 2.8%, up from 2.5% in April, the fastest rate since early 2012. CPI has been pushing higher largely due to the price of transportation and housing; gasoline and shelter were the biggest factors in the seasonally adjusted increase.

Many experts believe that efficiencies in the economy, led by companies like Amazon and Uber, have changed the dynamics of productivity and helped to hold prices lower than expectations. One study by Austan Goolsbee of the University of Chicago and Peter Klenow of Stanford found that prices for goods sold on the internet rose much slower from 2014 to 2017 than indicated by traditional measures like the Consumer Price Index. Companies like Amazon and other online firms have essentially made it possible for direct factory to customer sales and thus eliminating the middleman. Traditional distribution channels such as department stores have a relatively high infrastructure costs and pressure will remain on them to change their business models or go out of business. These types of massive shifts in savings and efficiency need time to work their way through the economy before effected sectors have real price pressures.

Narrowing Yield Curve

While everyone seems to be enjoying the benefits of digital transformation and e-commerce, there is growing concern about a narrowing yield curve which could signal a recession on the horizon. Scott Minerd, the Chief Investment Officer at Guggenheim, a $246 billion asset manager, said recently at an S&P Global Ratings conference that “If you look at the historical path that we’ve been on, we are just around the point where we would be, let’s say, maybe 22 months away from a recession.”

Currently, the two year vs. ten year treasury yield spread has dropped to .35 on June 14th, the lowest level since August 2007.

Chart - Quarterly Averages since 2005
Volumes Exploding in Interest Rate Products

With a narrowing of the yield curve, traders are taking advantage of arbitrage opportunities across the board with volumes rising dramatically in Treasury Note, Bond, and Eurodollar futures at the CME Group. The exchange’s May 10-year Treasury note futures traded 93.3% more contracts in May 2018 than in April 2018 with 53 million contracts changing hands in May versus 27 million contracts in April. Eurodollar futures volume was higher by 27.3%; May traded 68 million contracts traded versus 54 million in April. The 30 Year Bond Futures volume at CME Group rose 81.7% with 10 million contracts traded in May versus 5 million in April. The chart below outlines the largest interest rate futures products by volume at CME Group:

Chart - CME Group Interest Rate Futures Monthly Volume

Trading Opportunities with Straits Financial

With so many dynamic changes happening in the economy, and interest rate increases creating volatility, traders can take advantage of trading opportunities in interest rates with Straits Financial. As a member of the CME Group, we offer clients access to a full suite of interest rate derivatives including Treasury Notes, Bonds, Eurodollars, Swaps, and OTC listed interest rate products. Straits connects traders to overseas futures products through our global offices; and with your account at Straits Financial, you can trade the world. To connect with one of our global team members, please contacts Straits in the US at +1 312 462 4499 or in Singapore at +65 6672 9669.

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DISCLAIMER: This document is issued for information purposes only. This document is not intended, and should not under any circumstances to be construed as an offer or solicitation to buy or sell, nor financial advice or recommendation in relation to any capital market product. All the information contained herein is based on publicly available information and has been obtained from sources that Straits Financial believes to be reliable and correct at the time of publishing this document. Straits Financial will not be liable for any loss or damage of any kind (whether direct, indirect or consequential losses or other economic loss of any kind) suffered due to any omission, error, inaccuracy, incompleteness, or otherwise, any reliance on such information. Past performance or historical record of futures contracts, derivatives contracts, and commodities is not indicative of the future performance. The information in this document is subject to change without notice.  The impact on market prices due to seasonal or market cycles and current news events may already be reflected in market prices.