Bond Traders Start to Buy Into Yellen's Path on Interest Rates

  • Market still projects gradual pace of Fed tightening
  • Two-year Treasuries post their worst week since February

The bond market is beginning to warm up to Federal Reserve Chair Janet Yellen’s message on interest rates.

Friday’s better-than-forecast jobs report sent Treasury yields soaring and prompted futures traders to increase bets that the Fed will raise its benchmark rate from near zero at its next meeting. They also pulled forward projections for a second interest-rate increase to July or August of next year, compared with September or October before the data. Yellen said on Wednesday that she anticipates U.S. growth will warrant a rise in interest rates this year, and has repeatedly stated that she expects a gradual pace of rate increases after that.

Traders have stuck to bets all year that the frequency of interest-rate increases would be even slower than Fed officials’ forecasts. While the market still remains a long way away from the central bank’s so-called “dots,” a compilation of Fed member projections, traders’ expectations are inching toward the path policy makers have laid out for interest rates.

“The super-dovish scenario is getting much less weight, so the market is moving closer” to officials’ projections, said Steven Englander, global head of Group-of-10 foreign exchange-strategy at Citigroup Inc. in New York.

The dots show that policy makers expect the fed funds rate to rise to 1.375 percent by the end of next year, and then 2.625 percent the year after that, which would involve a rate increase every quarter. Futures traders aren’t so hawkish, pricing in about two hikes per year.

Fed Odds

Traders had already been ratcheting up expectations for a December rate increase before the jobs report. Futures prices indicated a just 50 percent chance of a hike by year end on Monday.

Those chances rose to 56 percent on Wednesday after Yellen spoke, then jumped to 68 percent after the jobs report. That helped drive up the two-year Treasury yield, the coupon maturity most sensitive to changes in Fed policy, by 16 basis points, or 0.16 percentage point, to end the week at 0.89 percent.

"It’s more likely that the market will move closer to the three to four hikes that the dots were pointing to per year, not the one or two that was priced into the market one or two weeks ago," Englander said.

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