Bond Traders to Fed: Your Rate Forecasts Are Still Too Ambitious

QuickTake: The Fed Lifts Off
  • Derivatives market signaling two rate boosts likely next year
  • Policy makers projecting four moves in the year ahead

Debt traders anticipate fewer interest-rate increases next year than the Federal Reserve does, after the central bank lifted its target from near zero and pledged a gradual retreat from crisis-era borrowing costs.

Policy makers boosted their benchmark Wednesday for the first time since 2006, by a quarter-percentage point, and voiced confidence that inflation will quicken. Yet the derivatives market is pricing in roughly two Fed increases in 2016, compared with the four moves that Fed officials laid out in their latest quarterly forecasts.

As has been the case all year, traders are expressing doubt about Fed Chair Janet Yellen’s message that the forces damping inflation will prove fleeting. The longest-maturity Treasuries fared the best following the rate boost. The securities extended months of outperformance fueled by a tumble in energy prices that’s subdued inflation.

“The Fed has consistently overestimated economic growth as well as expectations around rate hikes,” said Brendan Murphy, who oversees $16.5 billion as director of global fixed income in Boston at Standish Mellon Asset Management Co. While the Fed refers to forces holding down inflation as transitory, “the market really thinks the factors are a bit more structural.”

Interest-rate derivatives traders see the fed funds rate at 0.835 percent at the end of next year, compared with the median outlook of central bank officials of 1.375 percent. Wall Street economists are more in line with the Fed -- the median forecast in a Bloomberg survey calls for a range of 1 percent to 1.25 percent in a year.

Fed officials kept their median projection for the funds rate steady in 2016, although they lowered it for subsequent years. For the end of 2017, the median fell to 2.375 percent from 2.625 percent, and the 2018 estimate dropped to 3.25 percent from 3.375 percent.

The funds rate opened Thursday at 0.35 percent, compared with 0.14 percent Wednesday, according to ICAP Plc, the world’s largest inter-dealer broker.

While policy makers viewed the move to end emergency-level rates as warranted, they noted risks to their economic outlook and said policy decisions depend on progress on economic growth and inflation. While job creation surpassed consensus forecasts the past two months, a report Wednesday showed a gauge of manufacturing stagnated last month.

“The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” the Fed said in its statement. “The actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

The bond market is pricing in an annual inflation rate of about 1.5 percent through 2025. Meanwhile, the inflation measure that Fed officials target rose 0.2 percent in October, short of their 2 percent goal.

Yellen said Wednesday that the policy-setting committee has “reasonable confidence” that inflation will accelerate, in part as the effects of cheap oil fade. Crude fell this week to the lowest since 2009.

“The Fed is a little too optimistic about meeting their inflation target,” said Tim Horan, chief investment officer for fixed income in New York at Chilton Trust Co., which oversees $4.5 billion. “We will see containment in Treasury yields at the longer end of the curve because we don’t have an inflation problem.”

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