The Financial Times: Markets read the Fed rate runes

by Robin Wigglesworth

Financial markets have been remarkably placid so far this month, given August’s turmoil and the looming Federal Reserve meeting this week, when officials could tighten monetary policy for the first time in almost a decade. But investors are mostly sanguine at the possibility.

Many simply do not think the Fed will act, given the recent financial turbulence, the patchiness of the US economy, the strong dollar, subdued inflation and rising concerns over developing economies — especially China. Goldman Sachs’s Jan Hatzius estimates that the subsequent tightening of financial conditions is roughly equal to three rate increases.

“In our view, the recent events have largely sealed the case against a rate hike,” Mr Hatzius wrote in a note, reiterating his forecast for a December rise, but also opening up the possibility that the Fed stays on hold until 2016. Policymakers might not agree, but “to us the economic case for a lengthier delay looks strong”.

Markets appear to be leaning the same way. Interest rate futures indicate there is now just a 28 per cent chance that the central bank will lift its benchmark interest rate by a quarter point on Thursday. Indeed, money market derivatives indicate there is almost an even chance that the Fed stays on hold until next year, and traders are only pricing in a handful of rate rises in 2016.

Ralph Segall, the chief investment officer of Segall Bryant & Hamill, says he has also become less convinced the Fed should and will lift interest rates this week. “Looking at the guts of the market, I wouldn’t raise,” he admits.

But even investors and analysts who expect the US economy and employment picture to be strong enough to force the Fed’s hand into a rate increase this week do not expect any severe ructions as a result, after months of preparation for lift-off.

“Markets were prepared for this a year ago,” says Rick Rieder, chief investment officer for fixed income at BlackRock.

He reckons there is about a 40 per cent chance of the Fed tightening monetary policy this week; a 15 per cent chance if it waits until October; a 25 per cent chance of a December move; and a 20 per cent possibility the US central bank holds steady until next year. But Mr Rieder predicts that if markets remain tranquil this week the odds of a rate rise on Thursday will approach evens.

The chatter of financial markets in recent weeks has been of a “dovish hike”, where the Fed lifts once this month, then signals that it will pause any further tightening until it has fully assessed the impact — or “one and done” as industry wags have dubbed it. The press conference and accompanying forecasts would be used to reinforce the Fed’s dovishness, ameliorating any fallout from the rise.

“It will be a case of watching Janet Yellen’s lips very carefully,” says Nicholas Gartside, the head of international fixed income at JPMorgan Asset Management. “We are about to have the first rate hike in almost a decade, so the communication is very challenging, but there has been a lot of stability in bond markets recently.”

In fact, while the interest rate futures market indicates that most traders are betting the Fed holds this week, the Treasury market indicates that bond investors are more prepared for a rate rise, argues Douglas Peebles, head of fixed income at AllianceBernstein.

The yield of the two-year Treasury note — which is the most sensitive to interest rate changes — hit a four-year high of 0.76 per cent last week. It dipped slightly lower on Friday, but the yield remains well above the low of 0.41 per cent touched in mid-January, when the US economy suffered a bad cold from the freezing winter weather.

“The two-year note tells me that the Fed is going to hike soon,” Mr Peebles says. “Markets are uncertain of exactly when, but it’s clearly coming . . . Markets have actually been acting like the Fed started tightening since July 2014, when they stopped growing their balance sheet.”

Some money managers reckon that the removal of a big source of uncertainty for the past year could even trigger a relief rally. “Markets are now more set up and prepared for normalisation than they are for more uncertainty,” Mr. Rieder argues.

However, a minority of investors and analysts remain concerned that an unexpected interest rate increase will inevitably trigger turbulence in financial markets, given the current complacence.

Bank of America Merrill Lynch analysts say the idea of a market-pleasing dovish hike is a “myth”, given the difficulty of delivering a message and revised forecasts that are even more muted than currently priced in by investors.

Mr. Segall frets that some could be badly wrong-footed if the Fed decides to defy the doves and tightens monetary policy on Thursday. “What scares me are the unintended consequences,” he says. “It could really bite some people if they’re leaning the wrong way.”

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