Stock market lifted as traders bet on downshift in size of Fed rate hikes

By William Watts

Fed-funds futures show 94% probability of a quarter-point hike in February

After a series of supersize rate hikes in 2022, traders are overwhelmingly betting on a standard quarter-point rise from the Federal Reserve at its first meeting of 2023 following a further slowdown in inflation and remarks by policy makers.

Fed-funds futures on Thursday reflected a 94.2% probability the Federal Open Market Committee will raise the benchmark rate by 25 basis points, or a quarter percentage point, to a range of 4.5%-4.75% from its current range of 4.25%-4.5% when it concludes a two-day meeting on Feb. 1, according to the CME FedWatch Tool. There’s just a 5.8% chance the fed-funds rate will rise 50 basis points to 4.75%-5%.

“U.S. inflation shows price pressures are easing, yet in an environment of a strong jobs market, the Federal Reserve will be wary of calling the top in interest rates. A 25bp (basis point) hike in February is likely with a further 25bp in March. Inflation will slow even more meaningfully in 2Q though, with the prospects for 2H rate cuts looking strong as recession bites hard,” said James Knightley, chief international economist at ING, in a note.

The Fed delivered a series of 75 basis point rate increases in 2022, capping the year with a half-point rise in December as it moved aggressively to tighten monetary policy in its effort to bring down inflation that hit a nearly 40-year high. That was a departure from the Fed’s usual practice of moving rates up or down in quarter-point increments.

Bets on a quarter-point rise rose Thursday after the December consumer-price index affirmed expectations for a further slowdown in inflation. Also, Philadelphia Federal Reserve Bank President Patrick Harker, a voting member this year of the rate setting FOMC, said that quarter-point moves would likely be appropriate “going forward.”

Fed-funds futures had reflected a 76.7% chance of a quarter-point move on Wednesday and a 62.6% probability a week ago. A month ago, traders had seen a 51% chance of a half-point hike and nearly 14% chance of another 75 basis point move, while the probability of a quarter-point rise stood at just 35.1%.

Fed-funds futures reflect a 76.3% probability of another quarter-point rise in March, with a 19.1% chance of a pause and a 4.6% possibility of a half-point rise.

The market reflects only a 1.1% probability the fed-funds rate will end the year above 5%, which may reflect a further disconnect between financial market participants and the Fed. Policy makers have emphasized they expect the fed-funds rate to peak above 5% and then remain there for a lengthy period.

Harker said he thought the Fed should raise its rates slightly above 5% and then “we sit there.”

St. Louis Fed President James Bullard on Thursday reiterated his desire to see the fed-funds rate move quickly above 5%. “My preference is it would be appropriate to get there as soon as possible,” Bullard said. “I don’t see any purpose in dragging things out.”

But increasing confidence in the prospect of a downshift in the pace of rate increases was seen as the main driver for gains by both stocks and bonds on Thursday. After a choppy start, the Dow Jones Industrial Average was up 265 points, or 0.8%, while the S&P 500 rose 0.6% and the Nasdaq Composite gained 0.7%.

The yield on the policy-sensitive 2-year Treasury note fell around 11 basis points to 4.115%, while the 10-year Treasury note yield dropped 11 basis points to 3.444%. Yields and debt prices move opposite each other.

“Harker’s comments are what moved the market as it clearly outlines what the Fed’s path playbook will be for the rest of the year. The Fed appears poised to deliver a 25 bp rate hike at the Feb. 1 meeting, then be data-dependent” for the subsequent meetings, said Edward Moya, senior markets analyst at Oanda, in a note.

-William Watts

(END) Dow Jones Newswires

01-12-23 1420ET

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