It’s become a bit passé by now to highlight the big hawkish shift in the traders’ expectations for next week’s FOMC meeting; unless you’ve been living under a rock, you know the market-implied likelihood of a 25bps rate hike has shifted from relatively unlikely (85%) in the last couple of weeks, driven by a run of solid economic data and more importantly, essentially-unanimous hawkish “Fedspeak” in favor of such a move.

Perhaps a more important development has been the simultaneous increase in the amount of tightening priced in, not just the timing of the year’s first interest rate rise. As of writing, the CME’s FedWatch tool shows that Fed Funds Futures traders think it’s more likely than not that the Fed will be able to raise interest rates thrice this year, making it the first time in years that the Fed has not been far more optimistic than the market as a whole!

So are these hawkish expectations warranted?

At Faraday Research, we don’t necessarily feel that we have an edge interpreting the myriad economic reports that are released on a daily basis. Instead, we pride ourselves on integrating price information from multiple markets to confirm or deny our views. By utilizing the principles of intermarket analysis and relationships between different subsets of stocks, bonds, commodities and currencies, we increase the probability of successfully separating the signal from the noise in the markets’ day-to-day price action.

Applying these principles to the short-term treasury market (SHY), which is most sensitive to Fed expectations, shows that, if anything, the bond market’s expectations may be too conservative!

Certain sectors of the stock market tend to be closely correlated with the outlook for interest rates. For instance, banking stocks tend to make money on the “net interest margin” between their liabilities (checking and savings accounts, CDs, etc) and their assets (mortgages issued, car loans, etc). This margin tends to rise with the general level of interest rates, so outperformance of the banking sector (KBE) relative to the broader market can provide an indication of stock market investors’ outlook for interest rates.