Is the Market Underpricing the Risk of Fed Hikes?

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According to the CME’s FedWatch tool, futures prices as of January 16 implied that there was no chance that the Federal Reserve will raise its short-term interest rate target band from 3.5%-3.75% over the course of 2026. Market prices implied that there was only a 2% chance that the short rate target could rise by the end of 2027, although that may simply reflect wider uncertainty about outcomes nearly two years in the future rather than a considered view on the actual likelihood of that happening. By contrast, the implied probability that the Fed will lower rates by at least 0.25 percentage points over the next 12 months is over 90%.These modal probabilities may prove to be accurate forecasts, especially if the current administration succeeds in suborning the central bank to its whims. (As of January 20, the implied odds of a rate increase by the end of 2027 have increased to almost 6%, possibly as a consequence of financial asset sales by European investors in response to the Trump administration’s wanton aggression over Greenland.) But there are nevertheless good reasons to think that the implied probability of rate increases over the next two years is too low. The latest data on retail spending, on the job market, on inflation, and on household balance sheets are all consistent with an economy that is not obviously in need of lower borrowing costs.In fact, the big risk is (still) that a reduction in rates could unlock the $16 trillion in un-monetized housing wealth that has built up since the end of 2019, leading to a flood of additional consumer spending. If businesses…