Fedwatch: the trajectory of expected hikes

The Federal Reserve started by talking the talk, but now they're actually walking the walk. Effectuating a tightening of policy that in some ways is rather unprecedented should it continue as planned. The May 4th policy announcement brought us the beginning of quantitative tightening (QT) on June 1st as well as a 50 bps hike.

QT is set to be implemented as follows, at least for now (from the Federal Reserve's website):

• Roll over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing in the calendar month of June that exceeds a monthly cap of $30 billion. Redeem Treasury coupon securities up to this monthly cap and Treasury bills to the extent that coupon principal payments are less than the monthly cap.
  

• Reinvest into agency mortgage-backed securities (MBS) the amount of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received in the calendar month of June that exceeds a monthly cap of $17.5 billion.

The good news is that this is a roll-off, rather than an active distribution of balance sheet holdings. That helps to reduce the amount of liquidity pressure it may put on financial markets. The bad news is that the markets are barely able to survive without QE.

Even now, the Fed continues to step in to non-competitive treasury auctions and buy in size to replenish their balance sheet. Once that slows (and eventually stops) it could create more volatility within treasury securities, though the US Treasury Department's most recent debt issuance schedule suggests that the aggregate amount of treasuries sold will decrease by $69 billion quarter over quarter. This will, at least at some level, blunt the impact of the Fed's treasury security roll-off from their balance sheet, as the net impact of a $30 billion per month roll-off will be met by a $23 billion per month reduction in treasury issuance.

When eyeing the upcoming June 15th Fed policy announcement, observers in Fed funds futures are currently expecting a 92.5% probability of a 50 bps hike from the current policy rate of 75-100 bps up to 125-150 bps. Chances of a 75 bps hike have fallen after multiple Fed members, including Chair Jerome Powell, have talked that possibility down. It is important to remember that the Fed does use a policy range rather than a hard target. This is why we see the variability in the above chart's rate targets for each probable outcome.

At present the Fed seems set to continue down the path of 50 bps hikes for June and July, then moving toward a 25 bps hike schedule for September through February, and slowing their hiking pace from there. The Fed funds policy range expected by July 26th of 2023 is currently 300-325 bps, an increase of 225 bps from the current policy range.

Whether or not the economy and financial markets can stomach such a rate hiking (and QT) schedule is another question altogether. What we do know is there's a reasonable correlation between the aggregate size of major central bank balance sheets and the performance of risk assets, like stocks.

As central banks raise rates and remove liquidity from their respective financial markets, it is typically a major headwind as rising rates mean increasing risk premia across a number asset classes, and the increasing abundance of central bank liquidity has been a major driver of upward price revisions. Thus without it we could be in for a rocky road ahead.