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Investors Are Betting That the Fed Hits Pause on Rate Hikes

Daniel Kruger
Federal Reserve Board Chairman Jerome Powell speaks during his news conference after a Federal Open Market Committee meeting in Washington, U.S., December 19, 2018. REUTERS/Yuri Gripas

Investors increasingly believe the Federal Reserve won’t raise interest rates in 2019, a sign of fading confidence that the U.S. economic expansion will continue at the stable pace the central bank foresaw just two weeks ago.

Whether investors are right will turn on how much U.S. economic growth slows in 2019, and the degree to which recent market volatility curbs business investment and hiring and weighs on consumer spending.

Fed officials already expect the U.S. growth rate to moderate this year as it faces slower growth abroad, waning government stimulus measures and the continued effects of the Fed’s moves to drain its own monetary boost.

For investors’ bets to prove prescient, growth would need to slow below the 2.3% rate Fed officials expected when they raised rates last month and penciled in two more increases for 2019. The recent market turbulence could make investor skittishness a self-fulfilling prophecy.

Fed-funds futures, which investors use to bet on the direction of Fed policy, on Wednesday showed a 91% probability that the central bank’s policy makers will finish the year with interest rates at or below their current level. That is a reversal from early November, when futures prices indicated a 90% probability that rates would end 2019 higher than they are now.

Futures even show a small chance that rates will fall this year—raising the possibility of a market shock or economic downturn by year’s end.

On Wednesday, U.S. stocks closed slightly higher after a tumultuous opening session of 2019. The Dow Jones Industrial Average finished up 18.78 points, or less than 0.1%, at 23346.24, after flipping between gains and losses. The S&P 500 added 3.18 points, or 0.1%, to 2510.03, while the Nasdaq Composite rose 30.66 points, or 0.5%, to 6665.94.

The yield on the 10-year Treasury note—a reference rate for everything from mortgages to corporate loans—settled at 2.659%, its lowest close in almost a year. The yield, which falls as bond prices rise, tumbled back below 3% in recent weeks after reaching multiyear highs in November.

Fed officials last raised rates by a quarter-percentage point to a range between 2.25% and 2.5% when they met Dec. 19. They also projected two more rate increases, but those boosts rely on a forecast that the economy will grow 2.3% this year, still above the 1.8% pace officials deem is likely over the long run.

If the economy looked likely to slow to a growth rate closer to the lower long-run trend, that would remove the impetus for rate increases this year. Signs that growth is likely to decline by more than officials project raise the chance that the Fed pauses in March from its recent quarterly pace of increases.

In the two weeks since Fed officials last met, stocks have fallen, yields on corporate debt have widened relative to those on safer government bonds and other measures of financial conditions have tightened considerably.

By raising costs for businesses and households to borrow and invest, tighter conditions could slow growth more than central-bank officials anticipated.

Fed officials made relatively modest changes to their growth projection: Their median growth forecast for 2019 edged down to 2.3% from the 2.5% they had projected in September. Because financial conditions had also tightened, the downward revision was enough to reduce the median projection by analysts of fed-funds rate increases in 2019 to two from three.

This sets up a tension between the central bank—which must manage rates in keeping with its twin goals of stable prices and full employment—and investors, many of whom would prefer looser monetary policy.

The Fed’s rate increases have also attracted criticism from President Trump. Mr. Trump said stocks had faced a “little glitch” last month but predicted they would recover at a cabinet meeting Wednesday. “We need a little help from the Fed,” he said.

Meanwhile, a key bond-yield indicator tracked by Fed economists is signaling rates could be cut in 2020.

Research published last summer by economists Eric Engstrom and Steve Sharpe said comparing the difference between the yields on three-month Treasury bills and the yield implied by futures markets for the same bills some six quarters later produced a more reliable gauge of market-derived recession probabilities than traditional measures of the yield curve, such as the spread between two- and 10-year Treasurys.

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This “near-term forward spread” turned negative on Wednesday for the first time since March 2008.

“The predictive power of our near-term forward spread indicates that, when market participants expected—and priced in—a monetary policy easing over the next 18 months, their fears were validated more often than not,” wrote Messrs. Engstrom and Sharpe.

Fed Chairman Jerome Powell has said that the Fed’s policy isn’t on a fixed course and that it reacts to changes in the economy. At a press conference last month he pointed to the Fed’s decision to slow the pace of rate increases in 2016 after worries of a growth slowdown in China fanned fears of recession. After projecting four rate increases in December 2015, the Fed raised its benchmark rate just once in 2016.

“We know that the economy may not be as kind to our forecasts next year as it was this year,” Mr. Powell said last month. “Unforeseen events as the year unfolds may buffet the economy and call for more than a slight change from the policy projections released today.”

Tighter financial conditions haven’t yet shown up in most economic data, but a handful of recent surveys have pointed to softer manufacturing activity. An index that tracks U.S. manufacturing activity is set to be released Thursday morning by the Institute for Supply Management. Economists surveyed by The Wall Street Journal expect the index reading to decline to 57.9 in December from 59.3 in November.

Tighter financial conditions and weaker U.S. data prompted economists at Goldman Sachs last week to revise down their U.S. growth forecast for the first half of this year to 2% from 2.4%. They expect 1.8% growth in the second half.

Meantime, economists at Morgan Stanley expect the economy to grow just 1.7% this year, the slowest pace since 2012, with quarterly growth declining to a low of 1% in the July-to-September quarter.

Write to Daniel Kruger at Daniel.Kruger@wsj.com and Nick Timiraos at nick.timiraos@wsj.com



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