FED RATE RISE MUST COME TO TERMS WITH INVESTORS / THE WALL STREET JOURNAL

Heard on the Street

Fed Rate Rise Must Come to Terms With Investors

If Fed’s Views Differ Too Much From Market’s Turmoil Could Result When Rates Change

By Justin Lahart

April 2, 2015 2:48 p.m. ET

The gulf between what the Federal Reserve thinks it will do with interest rates and what the credit market is implying will happen might not be as wide as it seems. Even so, investors could find themselves on shaky ground.

As the Fed prepares to undertake an unprecedented move away from its zero-rates policy of the past six years, investors are having a hard time gauging when and by how much things will change. That is especially understandable given conflicting signals being sent by jobs and inflation.

If markets and the Fed get too far apart in their views, turmoil could result when rates change.

Fortunately for the Fed, one gauge of the market’s expectations shows investors may be more on the same page than would be immediately apparent from things like Treasury yields. While that could provide some comfort, though, the Fed can’t completely ignore the possibility markets get jolted.

At their meeting last month, Fed policy makers lowered the trajectory for where they see their interest-rate target going in the years ahead. Their median projection calls for a 0.625% rate at the end of this year, compared with an earlier forecast of 1.125%. That suggests they will put through just two 0.25-percentage-point increases to their target range (now set at zero to 0.25%) by year-end. The Fed’s September and December meetings seem the most obvious candidates.

But federal-funds futures, which price off rate expectations, imply overnight rates will finish the year at just under 0.5%. That equates to a forecast the Fed is more likely to raise rates once, not twice, this year.

The mismatch doesn’t end there. Fed policy makers project overnight rates will hit 1.875% by the end of next year and 3.125% the year after. Back-of-the-envelope calculations suggest overnight rates will average around 0.9% over the next two years. Meanwhile, two-year Treasurys yield just 0.54%.

The differing views haven’t gone unnoticed by policy makers. Just last week, Fed Chairwoman Janet Yellen noted markets are geared toward “a lower and flatter trajectory” for overnight rates than the central bank envisions.

But the rate path implied by markets reflects not only where investors forecast the Fed will set policy. It also encapsulates the risk the market’s own forecast is wrong. That is embodied in what are dubbed term premiums.

This is essentially the extra yield investors demand over what they think is appropriate for a Treasury to compensate for the possibility their view is wrong.

The word “premium” is used because, in the past, the big risk was that inflation could come in hotter than expected, leading the Fed to tighten more than had been forecast. (While term premiums aren’t directly observable, economists have devised methods to infer them.) So, for example, an investor years ago who thought overnight rates would average, say, 5% over the life of a five-year Treasury might have demanded 6% to account for this risk.

Now, the term may be better called a term discount. That is because the risk in today’s lackluster inflation environment is that central banks stay lower for longer. In other words, investors demand a lower yield than would normally be expected. In turn, they are demanding a higher price, since yields and price move in inverse relation to each other.

Today, that discount for the two-year Treasury is 0.49 percentage points. Add that back to the current yield and the market’s view wouldn’t be far off the 0.9% average for rates over the next two years suggested by Fed projections.

That may provide some solace for policy makers worried an eventual move on rates will take investors unawares. The market may be better positioned for a changed interest-rate stance than it appears.

The trouble is the term premiums, or discounts, will adjust as the Fed’s intentions become clearer. And that could still give the Fed less room for maneuver in what will prove to be a difficult pivot.