With a Federal Reserve rate hike this week seen as a done deal, the best chance for bond-market volatility may lie in policy makers’ updated outlook for the pace of future tightening.
The central bank signaled in September that it expected three rate increases in 2018, as seen in what’s known as the dot plot, officials’ quarterly outlook for the path of policy. Given strengthening economic activity, policy makers should raise estimates for growth and anticipate lower unemployment — leaving roughly even odds that officials’ forecasts will coalesce around four 2018 hikes, according to JPMorgan Chase & Co.
Here’s the September dot plot:
Since traders aren’t fully pricing in two increases next year, let alone the three that policy makers project, a tweak to a more rapid tightening path could boost short-term yields and further flatten the curve, which is already the most compressed it’s been in a decade.
“If it moved from three to four hikes, the curve would flatten quite a bit,” said Gennadiy Goldberg, a rates strategist at TD Securities. It would indicate that officials “are seeing more rumblings of inflation, and would suggest to markets they are underpricing the Fed.”
TD predicts no change in the dots this week and forecasts two hikes next year. Lou Crandall at Wrightson ICAP LLC foresees an adjustment in March to four increases if Congress pushes through a tax cut.
As traders debate the likely pace of hikes, both hawkish and dovish structures are cropping up in the eurodollar market. Demand has been skewed toward hawkish put spreads, which stand to benefit should the Fed tighten at a faster clip than currently priced in. At the same time, some bullish bets have emerged through call spreads that would profit from a scenario where the Fed hikes this week and then pauses for the foreseeable future.
There’s another risk for the market: Traders may be underestimating the chance that turnover in the makeup of the Board next year could produce a more hawkish Fed, according to Bloomberg Intelligence analysts.