Markets Zero In on Pricing Fed’s Terminal Rate: Liquidity Watch
(Bloomberg) -- Traders have been obsessing when the Federal Reserve will start to raise interest rates and how fast it will go. The other preoccupation is over where they will end up.
Bets on tightening have been dialed up in recent weeks with eurodollar futures priced off the three-month London interbank offered rate now priced to fix around 2.25% by the first half of 2026. Taking into account the spread between these forward rate agreements and overnight index swaps, this implies the Fed funds will top out a touch above 2%.
The five-year forward five-year overnight swap rate is now priced at 2.30% -- that’s back where it was in May 2019 when the Fed funds rate was at the previous cycle high.
The Fed typically pushes its benchmark rate higher until it reaches what is known as the equilibrium rate, where the economy is able to run on its own without the central bank tapping the brakes or touching the accelerator.
The Fed’s longer-run median “dot” has been at 2.5% since June 2019 after trending lower virtually since it was first published in 2012. This follows the pattern of U.S. hiking cycles since the 1980s, which have all ended with a lower peak for the Fed funds rates.
If markets are thinking along the same lines as the Fed, they are unlikely to price in much more on the rate-hike front. There is still a chance however that traders may have their own ideas and anticipate a higher terminal rate in this business cycle, bucking the 40-year trend.
©2021 Bloomberg L.P.