Are interest rate hikes over? Assessing what the market thinks

For eighteen months now, Federal Reserve meetings have been must-see TV for anyone invested in the financial markets. The changes to the all-important federal funds rate, as well as the language from chairman Jerome Powell’s press conferences, have tossed around the market at will. 

After a rise from near-zero, we are now in a place where T-bills are paying well north of 5%. 

The drain on liquidity has been severe. The S&P 500 shed 20% of its value last year, its worst year since 2008. Meanwhile, the dollar strengthened against nearly every major currency as the world’s safe haven asset sucked up capital, with investors retreating quickly on the risk curve. 

And yet, despite the doom and gloom, a recession has not yet hit. Furthermore, in the latest Fed meeting last week, Fed chair Jerome Powell even announced that the Federal Reserve is no longer forecasted a recession to come at all, a notable departure from its previous position. 

Not only that, but markets have been sizzling thus far in 2023. After the aforementioned 20% loss in 2022, the S&P 500 has bounced back sharply and is now less than 5% off its all-time high, with big tech stocks in particular printing strong gains.

Much of the optimism is derived from the hope that interest rate hikes are finally coming to a close. This follows inflation dropping swiftly over the last two quarters, with the most recent numbers for June coming in at 3%, far below the 9.9% peak of last summer. 

But how likely are rate hikes to be over? And could we even see rate cuts? Well, the best way to analyse this is to back out probabilities implied by the fed futures market. Looking at this for the end-of-year meeting (December 2023), we see there is a 63% chance of the rate being the same as the current 5.25%-5.5%. While this is the likeliest outcome, it is far from guaranteed, and there is still a sizeable 27% chance of rates being 25 bps higher.

The other thing these probabilities convey is that there is minimal chance of rate cuts happening this year, at least as far as the market is concerned, with a 7% chance slapped on rates being 25 bps less. 

However, if we look out across a further time horizon, rate cuts firmly enter the picture. Assessing the probabilities implied by the futures market for the June 2024 meeting, we see only a 10% chance of rates being the same as current, while the chance of rates being higher is minuscule, at just 2%. 

Instead, rate cuts are the favourite. There is a 28% chance of rates being 25 bps lower, a 35% (the favourite) of being 50 bps lower, a 20% chance of being 75 bps lower, and even a 5% chance of minus 100 bps. 

All in all, the baseline expectation is that while there may be one more hike this year, we are very much on the home stretch with regard to tightening interest rate policy. 

However, there is reason to be cautious amid this pickup in sentiment. While inflation has come down strongly, once the volatile elements of food and energy are stripped out, the picture is not quite so rosy. This is the core inflation measure, and is typically used as more of a crutch by the Federal Reserve. As the below chart shows, this core number has been far stickier than the headline figure, and remains at 4.8%. 

Having said that, the picture is undoubtedly brighter than earlier this year. The headline figure may not be perfect, but it certainly shows that the cost-of-living crisis is cooling, even if the promised land of 2% has not been reached yet.

The real question is how much of all this is now priced in. While the Fed rescinding its recession forecast is great news, and the suffocating rate hikes appear to be coming to a close, that does not mean pain cannot lie ahead. Additionally, it is not as if the market has suddenly discovered all this; inflation has been ticking down all year, and stocks have been on upward trend as a result – the Nasdaq’s first half of the year was the best since 1983. 

So while a gruesome recession is far less likely, and the chance of a coveted soft landing feels less remote, that does not necessarily mean prices will continue to soar. Stocks have been red hot for months now (or, at least the big tech companies have been), and the bargains of last year are no longer trading at such cheap valuations. 

But either way, it appears that after eighteen months of rate hikes, the end may finally be approaching. Beyond that, it’s all in flux.