With Federal Reserve policy set to change in the coming months, we should consider whether the Fed plans to lead or follow the market.

If the Fed leads with a much larger interest rate hike than traders expect — like 1% — it should create a large move in the stock and bond markets. Higher interest rates and changes to the Fed’s balance sheet will surprise traders.

Fortunately, it doesn’t appear that the Fed plans on leading.

There were no significant surprises in the statement the Fed released after its meeting last week. Traders hadn’t expected any policy changes, and the Fed didn’t make any.

Look to Futures Markets for Traders’ Fed Expectations

Look to Futures Markets for Traders’ Fed Expectations

We can gain insights into what traders expect the Fed to do from futures markets.

The chart below shows the probability of a 0.25% rate hike, based on market prices of Fed funds futures. The probability topped 50% after the Fed’s December 15 meeting and reached 85% before the January meeting.

fed futures

Source: CME.

The Fed’s statement issued after the meeting also indicated that quantitative easing would end in March. That, too, was already expected.

There is a possibility the Fed will raise rates 0.5% in March. That would probably be bullish for stocks since it would show the Fed is serious about fighting inflation. But since Chair Jerome Powell has a history of following markets, a large hike is unlikely for now.

By the end of the year, traders expect short-term interest rates to be at least 1.25%. That’s more than many analysts expect.

The consensus among analysts seems to be the Fed will raise rates three times this year. Traders are pricing in five hikes. Analysts prepare research reports. Traders back their opinions with real dollars.

Bottom line: Powell will likely follow the market and push rates higher than analysts expect.

Michael Carr is the editor of True Options Masters, One Trade, Peak Velocity Trader and Precision Profits. He teaches technical analysis and quantitative technical analysis at the New York Institute of Finance. Follow him on Twitter @MichaelCarrGuru.

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