Bond Traders Uncover Secret to Rates That Fed Doesn’t Get

Yellen's Speech on Fed Policy, Economy in Two Minutes

Forget 2015. The real play for bond traders is 2016.

For years, the $12.6 trillion U.S. Treasury market has signaled -- correctly -- that the Federal Reserve was too optimistic in its outlook for the economy and interest rates.

That’s no different now even though policy makers have moved closer to how traders view the world, which is to say that it wouldn’t be surprising if the central bank failed to lift borrowing costs this year.

Despite the backup in yields in recent weeks, bond prices still signal the unexpected slowdown in the economy was more than just the result of some bad weather that kept Americans indoors and idled factories in the first quarter. Regardless of when the first increase comes, futures show traders don’t see rates exceeding 1 percent by the end of 2016, versus the Fed’s estimate of 1.875 percent.

Fed officials are “still optimistic and hopeful their policies are going to work the way they are intending,” Brandon Swensen, the co-head of U.S. fixed income at RBC Global Asset Management, which oversees $35 billion, said from Minneapolis. “What we have seen and what the market is pricing in is that it will be more of the same.”

RBC predicts rates will only rise to 1 percent by the end of 2016, from near zero now, and as a result holds a greater proportion of short-term Treasuries relative to its benchmark.

Too Optimistic

Since 2012, when the Fed started making its forecasts public, policy makers have consistently overestimated the strength of the economy.

They’ve cut their projections in nine of the past 10 meetings and chopped their year-end rate forecasts by at least a half-percentage point from 2015 through 2017.

As recently as September, the Fed’s median rate estimate for 2016 approached 3 percent. It’s now less than 2 percent, still a percentage point higher than what the market anticipates. And traders are divided over whether the central bank can start raising rates at all this year.

That pessimism has been reflected in yields on the 10-year note, which are still well below their most recent peak of 3.05 percent last year. They fell to 2.14 percent in New York today.

“The Fed has opinions; the market has positions,” said Jack McIntyre, who helps oversee $45 billion at Brandywine Global Investment Management in Philadelphia. “If the data doesn’t show marked improvement soon, they’re going to get pushed back into 2016.”

No Delay

Fed Chair Janet Yellen said Friday she still expects to raise rates this year if the economy meets her forecasts, with a gradual pace of tightening to follow.

She added that delaying the first increase until employment and inflation return to the Fed’s objectives “would risk overheating the economy.”

The problem is that a raft of disappointing data in the past month, from retail sales to consumer confidence and manufacturing, suggests there may be something more than just the weather that’s holding back growth.

That became evident after the recent collapse in energy prices produced a $150 billion windfall for Americans, according to Goldman Sachs Group Inc. Rather than spend it, as many analysts expected, Goldman says most the money was saved.

“The Fed doesn’t have any sort of magic potion to fix everything that ails the economy,” said Aaron Kohli, New York-based interest-rate strategist at BNP Paribas SA, one of 22 primary dealers that trade with the Fed. “The Fed can’t command people to spend money.”

Labor Strength

Societe Generale SA’s Aneta Markowska sees it differently.

The firm’s chief U.S. economist is confident any weakness is temporary and suggests the bond market may not appreciate how a strong labor market will translate into faster inflation -- and higher rates -- in the months to come.

Last year, the U.S. added more jobs than at any time since

1999. And excluding what households pay for food and fuel, consumer prices increased more than forecast in April, edging closer to the Fed’s goal.

“The idea that we’re at zero rates and the labor market is at full employment: those ideas just don’t fit together,” Markowska said from New York. SocGen predicts the central bank will raise rates twice this year and lift them to 2 percent by the end of 2016.

She also points to policy makers such as New York Fed President William Dudley, who have voiced concern that keeping rates low for too long threatens to create asset bubbles.

Low Equilibrium

Nevertheless, there are some signs that a number of Fed officials are starting to question whether the central bank needs to re-think its approach to monetary policy.

In the minutes of the Fed’s meeting on April 28, some said the “equilibrium rate,” or economist speak for where interest rates need to be to achieve full employment and stable inflation, is “unusually low by historical standards.”

As a result, they asked whether the Fed was providing “sufficient accommodation” to the economy, even after holding its rate close to zero for more than six years and pumping trillion of dollars into the economy with quantitative easing.

“It justifies a low Fed funds rate,” said Margaret Kerins, the Chicago-based head of fixed-income strategy at Bank of Montreal, another primary dealer.

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