In assessing the trajectory of Fed policy the market is discounting, we prefer using the Fed funds futures contracts over the Eurodollar futures. The Fed funds settle at the average effective rate, while the Eurodollar futures contracts are three-month deposit rates. The Fed funds futures seem to be implying aggressive tightening by the Federal Reserve, which as of less than a month ago, half of whom did not expect a rate hike would be appropriate next year. The math of the Fed funds futures is fairly straightforward.
We need to make two assumptions for this exercise. The average effective rate has been steady at eight basis points since late August. The first neutral assumption is that it stays there, though there is a risk of it easing another couple of basis points. The other neutral assumption is that the Fed funds rate will remain at roughly the same place within the corridor as it is now. Because the tapering process will be over around the middle of next year, we see the September 2022 FOMC meeting as the first opportunity for the Fed to hike. Unlike the Bank of England that said it could raise rates before finishing its bond-buying, Fed Chair Powell has explicitly indicated that the US policy rate will not be lifted until QE has ended.
Fast-forward to next September. The FOMC meeting concludes on the 22nd. We assume that the Fed funds effective average will remain at 8 bp. Now imagine a 25 bp hike. That would likely boost the effective rate to 33 bp for the remainder of the month and mean an average for the month of slightly less than 15 bp. The implied yield of the September 2022 futures contract has ground higher since last month's FOMC, except for two sessions and today. It stands at 24 bp. How can that be? Is the market really discounting more than a 25 bp hike?
Yes, but let's look at the next year's calendar of FOMC meetings again. The first meeting in H2 22 concludes on July 28, so let's look at the August contract. If there is no hike at the July meeting, then fair value for the August contract will be around eight basis points. The March contract is at 8.5-9.0 basis points. The August contract's yield is about 11.5 bp means that a sixth (~14%) of a hike is discounted at the July FOMC meeting.
The economy is set to slow. Fiscal stimulus will fade. The pent-up consumer demand is satiated. The loss of federal unemployment insurance will weigh personal income and consumption. The Fed will be slowing its liquidity provisions as it tapers. Policy is set to be pro-cyclical, limiting how aggressive the Fed maybe next year. Already, one large investment bank has forecast no Fed hikes next year. The dollar is vulnerable if this view becomes, well, contagious, or even if the aggressiveness is pulled back a bit. We have seen other currencies, like the Canadian and New Zealand dollar, adjust lower when the market had second thoughts about the aggressive tightening that was discounted. We suspect that this broad assessment could also apply to sterling, where, egged on by officials, the market has priced in a small hike for as early as next month.