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  Market Insights: Market Implied Policy Rates: Lower for Longer

The Federal Open Market Committee (FOMC) chose to leave policy rates unchanged yesterday, as concerns of slower economic growth, disappointing inflation data, and recent global financial developments have clouded the outlook for economic activity. Prior to the Fed meeting, the implied probability of a September rate hike based on Fed Funds futures was under 30%, serving as a signal that the market was not expecting an increase in policy rates. Equities showed a similar sentiment, with markets rallying over the past several days on disappointing economic and inflation data. Unfortunately, the optimism faded shortly after the announcement, as equities erased gains and the U.S. dollar tumbled (Exhibit 1). Investors have become accustomed to the strong updward performance of risk assets following previous dovish comments from the Fed, making today’s response of “buy the rumor, sell the news” unusual. Perhaps global growth concerns in light of higher valuations and declining earnings are weighing on sentiment.

Exhibit 1: Dollar Index Spot (Intraday Price Graph, September 17, 2015)

Source: Bloomberg

When looking at the bond market, implied policy rates certainly indicate a more dovish outlook, and are arguably bearish from an economic growth perspective. Exhibit 2 highlights the current market implied policy curve relative to the curve at the beginning of 2015. The two year (1.13%) and three year (1.58%) market implied policy rates have declined significantly since the beginning of the year, a sign that investor expectations of economic growth and inflation are waning. In fact, market implied rates are more bearish relative to the Fed Median Forecasts published yesterday, which show the two year and three year forecasts at 2.6% and 3.4%, respectively . This may be an indication that the market doesn’t believe, or doesn’t agree with, the Fed. If the market is any indication, policy rates are likely to stay lower for longer unless we witness an uptick in inflation and growth data. Given yesterday’s response in equity, bond, and currency markets, we may see continued volatility in equities, declining Treasury yields, and some unwinding of the long dollar trade, as investors price in weaker growth and a slower pace of tightening in the U.S.

Exhibit 2: Market Implied Policy Curve (01/1/2015 vs. 09/17/2015)

Source: Bloomberg

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