Global equity markets are under sharp pressure and there’s even a whiff of panic here and there. Brutal sentiment in US stocks has led to huge declines for all manner of names over the past few days while currencies collapse across emerging markets and the commodities complex remains under massive pressure. All of this has gotten short-term interest rates traders much less optimistic on whether the FOMC will hike rates in September. As shown below, the Fed Funds futures market has priced out the first rate hike until January. The chart below shows the first date a Fed Funds future trades above 38 bps implied yield.
For a slightly more granular look at September, we do a more precise, nuanced calculation. We assume the FOMC moves the corridor for Fed Funds effective up from 0 to 25 bps to 25 to 50 bps. We assume Fed Funds effective settles in the same location within the range; for instance, with Fed Effective currently 15 bps, that means we would expect Fed Effective to set at 38 bps. When combined with an accurate day count adjustment for the average rate that the Fed Funds contract will settle on, we can calculate a precise probability of a September hike. We show two flavors of that probability below. Regardless of assumptions, we’ve seen an absolute knee-capping of expectations for a hike.
Whether you think the rally in short-term interest rates is justified or not is up to you, but it’s indisputable that the markets are assuming this equity market volatility – and possibly some of the global economic events being used to explain it – is going to put the Fed on hold. Another way to think about it: the Fed is being viewed as less likely to act, and there’s no support for stocks. Who knows whether the feedback loop should run from “Fed on hold -> stock market reaction” or “stock market down -> Fed on hold” but the fact is more dovish policy expectations in interest rate markets are doing precisely nothing to help equities. The last time we saw violent price action this way was October of last year; whether this episode resolves like October or to the downside is something the entire market is thinking about this afternoon.