• No.
  • Fed fund futures imply less of 30% change of the first hike on Sept. 17.
  • Surveys (e.g., Bloomberg, FT) suggest the odds are closer to 50/50.
  • More interestingly, the term structure of the yield curve already has one hike fully priced!!

One of the key arguments against an increase in fed funds on September 17th is the fact that the Fed has not provided a 'heads-up' and therefore the market is not prepared for it. It would be too disruptive to move away from the ZLB without the markets being prepared for it, the argument goes.

So, would markets really get surprised in the event of a liftoff?

The immediate answer is yes -- just look at the fed fund futures and you'll see that the probability of leaving the zero bound is as low as 30%. The Fed only moved in the last 20 years when the implied probability is north of 70%, Larry Summers recently said.

But looking at economist surveys, one gets a different picture. A Bloomberg survey shows that 51 out of 113 economists / strategists expect the Fed to move 25bp on Sept. 17th and 3 expect a move half this size. A similar survey by the FT shows 47% of 30 economists expect a move.

One may quickly dismiss surveys and argue that market prices provide a more accurate picture.

So, let's take a closer look at market prices other than Fed funds futures.
The term structure of the yield curve provides valuable information. From 1985 to 2007, 99% of the variance of the term structure of the yield curve can be explained by two factors (the first 2 PCA).

The chart below shows that using the common information provided in the 6m, 1y, 2y, 3y, 5y, 7y, 10y, 20y, and 30y constant maturity treasuries one can closely replicate the actual Fed funds rate. Note that the PCA calculated does not include the FF.


So it is clear that the term structure contains information on the fed funds rate. Note also how the blue line (FF compatible with the term structure) often (but not always) anticipates the move in the actual fed funds.

What if we use the model coefficients estimated up to 2007 (to avoid including the period of the crisis) to forecast where the fed funds rate should have settled, based only on the actual path of the yield curve term structure? (again, not using the actual fed funds).

The chart below shows that the estimated fed funds would have been negative for most of the ZLB period. Except for the last few months!

Zooming into the ZLB period, one can see that the term structure of the yield curve is compatible with a fed funds rate which has increased since Jan/2014 and matched the actual fed funds by November 2014.
The most recent data shows that the term structure is compatible with fed funds at about 35bp, exactly where the market expects the FF to trade after the first hike!


Bottom line: the term structure of the yield curve already embeds one hike.