Christopher Caparelli, CFA
As investors turn the calendar to 2015, one of the big uncertainties for the coming year is Fed policy and its impact on interest rates. In October, the Fed formally wrapped up its quantitative easing program, which saw the size of the central bank’s balance sheet grow from a pre-crisis $800 billion to almost $4.5 trillion. Now, the Fed can once again focus on the more traditional policy tool of manipulating short-term interest rates. Against a backdrop of steadily improving economic fundamentals and low inflation, the Fed has pledged to keep the Fed Funds rates low for a “considerable” period of time. Investors have loosely interpreted such Fed-speak to mean that the first rate hike is likely to occur sometime in the second half of 2015.
For a more precise estimate of the market’s interpretation, we can turn to the futures market for potential guidance. As of November 28, the futures market was predicting that the effective Fed Funds rate will rise from its current level of 0.10% to 0.25% by August of 2015, reaching a level of near 0.50% by the end of 2015. Unfortunately, as our chart of the week shows, the futures market has historically been a poor predictor of future interest rates. Since the 2008 Financial Crisis, futures contracts on the effective Fed Funds rate have serially overestimated the actual level of interest rates. So while 2015 is supposed to finally be the year that interest rates rise off historic lows, the futures market cannot be counted on to accurately predict the timing and magnitude of any increase.
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