The Tell: Market-implied odds of a policy error by Federal Reserve jump to roughly 40%, Credit Suisse says
The market-implied odds of the Federal Reserve committing a policy mistake have jumped to around 40% from just under 25% two weeks ago, according to an analysis of the eurodollar curve done by Credit Suisse.
Of all the scenarios being priced in by eurodollar traders, a policy mistake by the U.S. central bank outranks them all, Credit Suisse strategist Jonathan Cohn wrote in a note Wednesday. The policy mistake scenario is defined as one in which the Fed begins lifting interest rates in late 2022, but can only hike a few times before having to stop.
Rising inflation worldwide has markets now pricing in interest rate increases by central banks across much of the developed world, a dynamic which Cohn refers to as the “front loading” of hikes. Against this backdrop, the market-implied terminal rate, or level at which hikes would come to an end, has been declining in the U.S. — suggesting traders have reservations about the durability of a hiking cycle with an early liftoff, he says.
When taken with other scenarios also factored in by the market, “the
analysis supports the notion that uncertainty around the inflation outlook is
increasing the risk that the Fed will either fall behind or get ahead of the curve, so
to speak,” according to Cohn.
Eurodollars are the preferred tool of traders for expressing their views on future interest-rate moves. Under the policy mistake scenario, the target for the fed funds rate never gets above 1% between December 2022 and December 2028, from its current level between zero and 0.25%.
A second scenario gaining traction is the prospect of reflation, which has risen from zero to 20% in the past two weeks, as traders factor in a reduced likelihood of the Fed’s base-case scenario coming to fruition. The Fed has penciled in a 2022 start to its rate-hike cycle, with the terminal fed funds rate reaching about 2.5% over the longer term.
Until Tuesday, the U.S. Treasury yield curve had also recently been flashing concerns about a Fed policy error, with the spread between 2- and 10-year yields flattening amid concerns about Fed officials needing to tighten policy into a stagnating economy with persistently high inflation. That momentum shifted on Tuesday, with the curve steepening to as high as 126 basis points, the highest level in about a week, and is staying there on Wednesday.
Meanwhile, Treasury yields were little changed on Wednesday, with the 10-year rate
hovering around 1.64%. All three major stock indexes were headed higher, with the Dow industrials
and S&P 500
touching record territory.