MARKETS PLAY CHICKEN WITH FED OVER RATES / THE FINANCIAL TIMES COMMENT & ANALYSIS

Last updated: February 25, 2015 5:46 pm

Markets play chicken with Fed over rates

Michael Mackenzie

Volatility to rise if Fed acts sooner than assumed by bond markets
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©Reuters

Federal Reserve chairwoman Janet Yellen downplayed falling inflation and excess capacity

 

 

The US bond market may downplay the chance of interest rate rises arriving this summer; not so Janet Yellen.

The chairwoman of the US Federal Reserve has signalled that the central bank desires greater flexibility in terms of ending its current policy of maintaining near zero borrowing costs, introduced more than six years ago during the depths of the financial crisis.

Now with the US economy generating solid job gains, with the creation of more than 1m new positions since November, the stars are aligning for a normalisation of interest rates that could arrive in June and not later in the year, as forecast by the bond market.

The dawning prospect of the first US rate rise since 2006 remains a major point of uncertainty for how markets may perform this year. The bond market has long reflected a view that rate increases will be gradual and limited in scope, with investors focused on falling inflation pressures and an uncertain global backdrop.

 

Indeed, solid demand for new two-year notes sold after the latest Fed testimony on Tuesday resulted in the policy-sensitive yield dropping back below 0.6 per cent, illustrating how the bond market remains sanguine about the risk of rate rises.

 

Meanwhile, the S&P 500 reached a new record closing high, with markets soothed by the Fed chief stressing that any shift away from saying policy can remain ‘’patient’’ before raising interest rates does not signal imminent lift-off from near 0 per cent.

 

Ian Lyngen, strategist at CRT Capital, says the Fed can remove “patient” from its policy statement at next month’s meeting, without necessarily “signalling that tightening is a ‘couple’ of meetings away”.

Once the Fed drops its patient stance, however, rate rises could well arrive this summer should wage growth pick up and other indicators improve.

 

 

‘’Once you enter a tightening phase, flexibility becomes important,’’ says Alan Ruskin, strategist at Deutsche Bank. He adds: ‘’The door to a hike in June is open, even if she [Yellen] has not shown she plans to walk through it.”

 

Ms Yellen downplayed falling inflation and excess capacity, suggesting policy remains on hold for much of this year, and focused on the likely boost in growth from lower oil prices and a strengthening jobs market.

A long period of rock bottom borrowing costs and vast purchases of Treasury bonds by the Fed via several rounds of quantitative easing have spurred investors to embrace equities and own long maturity bonds, confident in the belief that the risk of sharply higher interest rates, which would deeply unsettle markets, remains low.

 

 

“QE led to a lot of money flowing into the US market, and now the concern is that we see flows reverse,’’ says Ashish Shah, head of global credit at AllianceBernstein. ‘’The Fed has a tough hand here: purely on US data, they should go, but they see threats from the global economy. Russia and Greece are tail risks for investors.”

 

Global concerns and low long-term market estimates of inflation, have supported a divergence over the extent of rate increases between the Fed and bond investors.

A central bank looking to push overnight borrowing costs beyond 1 per cent by the end of this year continues encountering scepticism from a market that expects a level about 0.5 per cent.

That gap may well narrow next month when policy makers release updated forecasts, with the Fed expecting a funds rate below 1 per cent.

Still, there is a concern in some quarters that the bond market remains too focused on falling inflation and global worries and has underplayed the prospect of a stronger domestic economy that runs at odds with overnight rates anchored near 0 per cent.

“The base case for the Fed remains at least two or more rate hikes, and that’s a problem for a market that believes the inflation and debt story will limit such a change in policy,’’ says Eric Green, economist at TD Securities. ‘’If you look at long-term inflation expectations, the bond market says the Fed will not reach their inflation target.”

A volatile summer could well ensue should the Fed decide to act sooner than assumed by bond traders.

“It does potentially set up a difficult reaction in the bond market if the Fed does follow through with a June rate hike,” says Anthony Valeri, investment strategist at LPL Financial. “The bond market simply isn’t priced to expect a June rate hike.”


Additional reporting by Tracy Alloway