The Doomsayer's Guide to the Fed, Rates and What Could Go Wrong

Best of the Web: Doomsayer’s Guide for Fed Outcome
  • Some Fed watchers warn that investors are still ill-prepared
  • Where the next ``crack'' emerges is tough to predict, BMO says

It’s the most closely dissected and highly anticipated decision on U.S. interest rates in recent memory.

Traders and analysts alike have had years to prepare.

So if the Federal Reserve finally does raise rates this week, what could possibly go wrong?

Plenty it seems. Some market watchers such as former U.S. Treasury Secretary Larry Summers are warning that financial markets still aren’t ready and could easily be caught off-guard. As Summers and others have pointed out, futures traders are pricing in just a 30 percent chance of an increase this week, based on the assumption the effective rate will average 0.375 percent after liftoff.

Even those who are relatively optimistic say there are weak spots that investors need to be wary of.

“It’s like a glass that has a crack in it,” said Aaron Kohli, an interest-rate strategist at BMO Capital Markets. “Predicting where that crack is going to spread is difficult to do.”

The pessimists have some ideas, though.

1) Short-End Tantrum: Two years ago, just a mention of ending the Fed’s stimulus caused long-term Treasury yields to soar. This time around, short-term U.S. debt may suffer the most, which prove to be an ugly surprise for those who sought refuge in the securities during last month’s stock-market rout. Investors have poured more money into the iShares 1-3 Year Treasury Bond ETF this year than any other exchange-traded debt fund. On Tuesday, the two-year note tumbled as yields soared to the highest since 2011.

There’s also the risk that selling from international investors will exacerbate losses in short-term Treasuries if the dollar, which almost everyone expects to rally as rates rise, slumps instead, according to Peter Tchir, the head of macro strategy with Brean Capital LLC.

2) Emerging Contagion: Developing countries that rely on foreign capital to finance their current account deficits are expected to face trouble, since higher rates in the U.S. would threaten to siphon that capital away. In a report last month, Morgan Stanley identified Brazil, Indonesia, South Africa and Turkey as the riskiest. UBS AG also listed Ukraine, Egypt and Venezuela as the most vulnerable, based on their debt and strength of finances.

“They’re all pretty dangerous,” said BMO’s Kohli.

3) Imperiled Borrowers: While it’s no surprise that higher rates would boost corporate borrowing costs, higher volatility in Treasuries could affect even the safest company debt. Last month, moves in investment-grade bonds were more correlated to Treasuries than any time in four years. And companies still have a significant financing needs, with borrowers looking to fund $458 billion of takeovers expected to close by year-end.

“If we get any significant selling pressure in the Treasury market, that’ll make it tougher for companies to issue debt,” said Tchir.

4) Structural Seizures: The rise of computers and the decline of Wall Street’s bond dealers as traditional middlemen has changed the nature of trading Treasuries in unpredictable ways. Last October’s “flash crash” in Treasury yields is just one example. Some analysts and strategists say a rate increase could have the potential to trigger even more volatility.

5) Risk of Standing Pat: Even so, there’s a growing group of pundits who say keeping rates at zero could lead to even bigger risks. That’s because a delay could trigger more turbulence in financial markets as traders try to decipher the Fed’s intentions. It also has the potential to spur more risk-taking in areas that are already overheated.

“The worst case for me is that they don’t go and we have to do this all over again,” said John Briggs, the head of strategy for the Americas at RBS Securities Inc.

(For more news about the Fed, see FEDU.)

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