A team of strategists at BAML said the Fed should surprise the markets
When it comes to the tricky task of raising interest rates, the Federal Reserve likes to prep investors before pulling the ripcord. It sees this as a way to prevent markets from reacting violently to unexpected news.
But this approach failed in December, when a well-telegraphed rate hike was followed by weeks of extreme volatility.
On Friday, a team of currency and interest-rate strategists at Bank of America Merill Lynch suggested that it might be time for a new approach.
As the following chart shows, the Fed hasn’t raised interest rates unless the market assigned it at least a 60% probability of doing so. This seems to contradict the Fed’s desire that every meeting be viewed by investors as potentially “live,” meaning the central bank could make a rate move at any one of its confabs.
This is great for minimizing volatility, the team said in a note released Friday. But it constrains the central bank’s ability to raise interest rates, sometimes forcing them to wait for a meeting with a pre-scheduled press conference before announcing any big decisions.
There’s a way to break this cycle. The Fed could set the historical norm aside and make one of its impending rate hikes at a meeting where markets aren’t pricing one in — though they were careful to rule out this happening in March.
One such surprise should be enough to convince markets that every meeting during this tightening cycle is a “live” meeting,” said Mark Cabana, rates strategist at BAML.
By surprising the market once, the Fed would regain some of the flexibility it has lost for fear of disturbing the markets.
“The Fed has been very reluctant to surprise and we think that’s likely to continue,” Cabana said.
“If it thought that economic conditions were appropriate and it wanted the market to assign greater odds that the fed would go, so that if they did surprise it wouldn’t have such an impact on financial conditions,” Cabana said.
So far, the likelihood of a rate hike in coming months is slim to none. For the Fed’s next policy meeting March 15-16, the probability of the central bank lifting rates is nil, according to the CME Group’s FedWatch tool. Odds are just 22% for April, 47% for June and the market isn’t pricing in a more than 60% likelihood until September.