The Federal Reserve is likely to slow the pace of its recent tightening when it delivers its final policy decision of the year later today in Washington, but traders are already focused on the prospect of rate cuts amid a softening of inflation pressures and the chances of a near-term recession.
The Fed has lifted its benchmark Fed Fund rate six times so far this year, including four consecutive increases of 0.75%, moves which, alongside the runoff of its $8.4 trillion balance sheet, mark one the most aggressive monetary tightening cycles in U.S. history.
Markets are pricing in an 80% chance that the Fed will hike that rate by 50 basis points, to a range of between 4.25% and 5%, when the decision in announced at 2:00 pm Eastern time in Washington.
The collective impact of rate hikes, however, has been mixed: consumer price inflation slowed notably in November, with headline CPI falling for five consecutive month and core prices rising at the slowest annual rate in nearly two years, but factory gate inflation continues to percolate and the historically-tight job market has continued to deliver persistent wage growth.
At the same time, Treasury bond yields continue to flash recession warnings, with benchmark 10-year Treasury note yields easing modestly to 3.499% in overnight trading, a level that is around 70 basis points south of 2-year notes in what is known as an 'inverted yield curve'.
According to a study from the San Francisco Federal Reserve, a sustained inversion has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
The Fed will publish a series of projections from its Board of Governors alongside today's rate decision showing where all 18 members (there is currently one vacancy) expect the mid-point of the Fed Funds rate to be at the end of each of the next three years. The so-called 'dot plots', which are published anonymously, provide markets with a broad indication as to where and when the Fed is likely to pause its current rate hike cycle.
Chair Jerome Powell hinted earlier this month that this so-called terminal rate could be higher than markets are currently forecast, and higher than the 4.625% predicted by the 'dot plot' published in September.
Fed officials noted in minutes of their early November meeting, however, that they may need to slow the pace of near-term hikes in order to better gauge their impact on growth and inflation, and their influence on financial markets, suggesting the prospect of a lower terminal rate from at least a portion of the group.
That, in turn, has some traders betting not only on smaller hikes over the next two meetings -- scheduled for February and March -- but also on the chance that the Fed will pause its tightening cycle by early spring.
"We think the Committee is gradually splitting between members who expect a steep drop in inflation as the pandemic-driven surge in margins reverses, followed by a softening in the labor market holding down medium-term inflation, and those who are skeptical on one or both ideas," said Ian Shepherdson of Pantheon Macroeconomics. "The absence of precedent on the first question, and the uncertainty over the extent of the coming labor market slowdown, means that reasonable people can disagree on both questions."
The CME Group's FedWatch suggests a 22% chance the Fed will hold rates steady at its March meeting -- following a 25 basis point rate hike in February -- with the balance of bets pointing to a Fed pause in May, when the Fed Funds rate tops out at between 4.75% and 5%.
Traders are placing a 50/50 chance on a Fed rate cut in September of next year, with those odds rising to around 70% by the November 2023 meeting.
All of these bets, however, could be torn to pieces by a hawkish press conference from Chairman Powell, who is scheduled to take questions from the media in Washington at 2:30 pm Eastern time.
"Historically, markets have done a pretty good job of predicting rate cuts, but with inflationary pressures still significantly above the Fed’s target, Powell may need to reset market expectations—again," cautioned Lawrence Gillum, fixed income strategist for LPL Financial.
"Markets have rallied three times this year on the expectation of a more accommodative Fed, but these rallies ended when expectations for Fed moderation proved too early," he said. "If there is forceful pushback, similar to the type of pushback Powell provided at the Jackson Hole Symposium in August, we could see another leg up in (Treasury yields).
