The Federal Reserve fund futures prices show that markets are expecting more easing from the Fed this year, probably as a result of the macroeconomic impact of the coronavirus outbreak.
Markets are pricing an 80% probability of at least one rate cut later this year. Chart 1 below shows that an additional cut in Fed rates by mid-year is already priced in, as the implied policy curve drops below the 1.50 lower bound rate at 6 months in.
Chart 1: Future money markets hold expectations of an additional Fed cut in the second half of the year
The biggest argument against a possible further reduction in rates is the favorable dynamics of the US labour market.
Despite the record low unemployment, the business volume continues to absorb labour force at a significant rate, which translates to higher wage and inflationary pressures.
With expectations of a rebound in the development of prices at the annual target of 2% in the coming months, the Fed holds up prospects of rate reductions while remaining vigilant of the potential effects of the coronavirus.
FOMC projections released December 2019 give no indication that FOMC members thought it would be necessary to cut rates, but markets seem more dovish.
Chart 2: Have markets turned too dovish on the Fed?
Some of the divergences can be attributed to markets leaning more dovish than the Fed over the past 18 months in general.
More importantly, markets have more information as they reflect today’s data, whereas the FOMC projections were released in December 2019 – prior to the coronavirus outbreak.
One rate cut this year seems possible in the event that the coronavirus is more persistent and severe than our base case.
However, the increased chances of a cut have not prevented the dollar from strengthening against most major currencies.
Ima Sammani: Junior FX Market Analyst at Monex Canada.
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