Chance of a Fed interest rate cut this year is on the rise

Fed hikes are off the table for 2016: Strategist

It seemed like not so long ago the Federal Reserve was telling markets to expect as many as four interest rate hikes this year.

Now, traders are beginning to give serious consideration to a rate cut before 2016 is over.

In fact, it really wasn't long ago that the U.S. central bank was gearing up for a substantial round of policy-tightening. At the Federal Open Market Committee's December meeting, officials indicated through the so-called dot plot that quarterly hikes were in order. The Fed enacted a quarter-point move at that meeting, the first hike in 9½ years.

However, a moribund U.S. economy combined with global rumblings — not least of them last week's Brexit vote — have changed the Fed's positioning. Where the bank was hoping to begin normalizing policy, markets now expect it to be on hold or even dialing back.

Traders are assigning an 18.3 percent chance for a rate cut in September or November, according to the latest readings on the CME's FedWatch tracker. There's just an 11.7 percent probability put on an increase before the end of the year, even though FOMC members, at their June meeting, indicated that they still expect two hikes.

The current futures market is allowing for no chance of a rate hike through November, and isn't fully pricing in a move until January 2017. In fact, futures pricing indicates a slight decline in the overnight funds rate, from 0.38 percent currently to 0.32 percent as the year closes.

Expectations for Fed accommodation also are playing out in the bond market.

The spread between yields on the U.S. two-year and 10-year notes broke through a key support level recently and is at its lowest level since the early days of the financial crisis, a year or so before the Fed went to near-zero on the funds rate. Fixed income traders are watching whether the curve will start to steepen, which would be likely if the Fed eases.

"The bigger question is whether we believe a longer-term steepening can take hold. For us, that inflection point will occur when the Fed moves more aggressively to actually provide some accommodation to the markets," Aaron Kohli, fixed income strategist at BMO Capital Markets, said in a note Tuesday morning. "That move is still some distance away as the Fed is unlikely to pivot from hiking to accommodation without an extended period of staying on hold."

The 10-year yield is around a four-year low and has dropped more than 36 percent this year.