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Traders Bet Fed Rate to Rise Year Before Late-2014 Pledge

Money-market derivative traders expect the U.S. central bank will lift its target rate for overnight loans a year earlier than Federal Reserve Chairman Ben S. Bernanke’s pledge of late 2014.

Treasury yields surged and money-market rates rose after Federal Open Market Committee members raised their assessment of the U.S. economy on March 13. The policy statement drove money- market derivative traders to bring forward the time when they predict the Fed will first lift its target of zero to 0.25 percent and damped speculation the Fed will buy more debt in a third round of quantitative easing, or QE3.

Forward markets for overnight index swaps, whose rate shows what traders expect the federal funds effective rate to average over the life of the contract, signal a quarter-percentage advance in approximately the September and October 2013 period, according to data compiled by Bloomberg as of March 15. Last month, such an increase in the effective rate wasn’t predicted until early 2014. This year the effective rate has averaged 0.15 percentage point below the top end of the target range that the Fed reiterated three days ago.

“In a week, the market has moved from focusing on how and when the Fed might do QE3 to when the Fed might start the tightening cycle,” said Brian Smedley, a strategist in New York at Bank of America Corp., in a telephone interview. “Not only has the market priced out QE3, but rates are pricing in Fed hikes a full year ahead of when the FOMC anticipates raising rates. In our view, it’s very hard to conceive of a scenario where the Bernanke Fed is raising rates in 2013.”

Economic Rebound

Data signaling the economic rebound is gaining steam emboldened traders to sell Treasuries and lift money-market rates amid positive sentiment from the central bank.

Retail sales jumped 1.1 percent in February, according to a U.S. Commerce Department report March 13. The Labor Department reported yesterday that initial jobless claims in the U.S. decreased in the week ended March 10 to 351,000, matching the lowest level in four years.

Yields on 10-year Treasury notes touched 2.35 percent today, the highest level in more than four months, while those on 30-year bonds rose to as high as 3.49 percent. The two-year note yield was 0.36 percent, up from 0.32 percent at the end of last week.

Move ‘Overdone’

“In the past few weeks, the market had been thinking the forward-rate structure it had priced in was too flat and had rates generally too low,” said Jim Lee, head of short-term markets and futures and options strategy in Stamford, Connecticut, at Royal Bank of Scotland Group Plc’s RBS Securities Inc. “There are still people thinking that this move is just beginning. However, it appears to me that it may be overdone,” said Lee, speaking in a phone interview.

The overnight index swap market is now pricing in cumulative Fed rate increases of 1.71 percentage points through the last quarter of 2015, up from a total of 1.27 percentage points a month ago, according to Lee’s calculations.

Overnight index swap rates, or OIS, are over-the-counter derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For U.S. dollar OIS, the floating rate is the daily effective federal funds rate, which was 0.14 percent on yesterday.

Fed’s Lacker

Federal Reserve Bank of Richmond President Jeffrey Lacker said today the U.S. central bank would likely need to raise interest rates next year.

“My current assessment is that an increase in interest rates is likely to be necessary some time in 2013,” Lacker said in a statement on the Richmond Fed’s website. He explained why he cast the sole dissenting vote on the FOMC’s March 13 statement that economic conditions are likely to warrant “exceptionally low” levels of the federal funds rate at least through late-2014.

“The economy is expanding at a moderate pace, and inflation is close to the committee’s 2 percent objective,” Lacker said. “As the expansion continues, the federal funds rate will need to rise in order to prevent the emergence of inflationary pressures.”

Forward OIS Rates

The forward OIS rates as well as implied yields on federal funds and Eurodollar futures contracts, which are used to gauge where traders speculate on the path of the Fed’s target rate, all rose this week. Both futures contracts trade on the CME Group exchange in Chicago in terms of price for an implied yield. Eurodollars are based on prediction for the three-month dollar London interbank offered rate, while fed funds contracts are bets on the Fed effective rate.

Fed funds futures, which were first offered on the Chicago Board of Trade in October 1988, indicate that traders bet the effective rate will average 0.44 percent during the month of November 2013. That’s up from an implied rate of 0.29 percent at the start of this month. The effective rate averaged 0.11 percent over the past month.

“This week has really been about people getting shaken out of their complacency and having to exit some trades that were based on nothing happening with Fed rates,” said Alexander Manzara, a Chicago-based futures broker at TJM Institutional Services, in a phone interview. “It’s not that the market has come to an idea that the Fed may move to raise rates sometime quickly. It’s about disappointment with the idea that QE3 is not imminent and that the U.S. data has been a little bit better.”

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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