• Market disconnect from Fed's rate path may fuel volatility
  • Traders wager on two rate increases next year; Fed sees four

Enjoy the holiday slowdown, bond traders. If analysts at Deutsche Bank AG are right, the market is going to get a lot more volatile.

After the Federal Reserve succeeded in nudging borrowing costs up from near zero last week in its first interest-rate increase since 2006, Treasury yields have hardly moved. Now, traders are betting low inflation and slow global growth will encourage policy makers to raise rates slowly in 2016.

The lull won’t last, according to Dominic Konstam, global head of rates research for Deutsche Bank in New York. He predicts the Fed will catch bond traders wrongfooted by raising rates in March. That may prompt a smaller version of the market “tantrum” seen in 2013, when the prospect of an end to Fed bond-buying fueled a sharp selloff in Treasuries.

“We call it a ‘baby tantrum,”’ Konstam said. "The idea is that the Fed’s tightening will look somewhat benign, and then you’ll realize that rates are rising to 1 percent. That’s a lot of stress" for markets.

The warning from Deutsche Bank, which has the second-largest share of the interest-rates trading business in the U.S. behind Goldman Sachs Group Inc., comes as expectations for Treasury-market volatility are tumbling. The Bank of America Merrill Lynch MOVE Index, which gauges implied volatility through options prices, fell to 66.02 this week, the lowest since December 2014.


Dot Plot

Early signals from the central bank indicate that policy makers may raise rates more quickly than traders expect. The median of the Fed’s so-called dot plot -- a chart sketching out officials’ projections for where rates will be in the future -- calls for them to reach 1.375 percent next year. That would constitute four 0.25 percentage point increases. On Monday, Federal Reserve Bank of Atlanta President Dennis Lockhart also suggested that the Fed may raise rates four times in 2016.

Futures prices show traders don’t buy into the Fed’s timeline. The market continues to expect two rate increases in 2016, according to data compiled by Bloomberg. Traders are pricing in a 56 percent chance that the Fed raises rates at or before its April meeting, based on the assumption that the effective fed funds rate will trade at the middle of the new FOMC target range after the next increase.

The yield on the benchmark 10-year Treasury note rose four basis points, or 0.04 percentage point, to 2.24 percent this week. The 2.25 percent note maturing in November 2025 fell 10/32, or $3.13 per $1,000 face amount, to 100 2/32.

The Damage

The last time the Fed sparked a Treasury-market tantrum, it wiped out about $1.5 trillion of bond-market value globally, according to Bank of America indexes. Konstam doesn’t expect the same amount of damage this time around. He forecasts the 10-year Treasury yield will peak around 2.75 percent close to the middle of next year.

After that, he predicts the Fed will hold off from further rate increases to make sure financial conditions haven’t tightened too much. That would alleviate some pressure on government-debt, prompting yields to fall back to around current levels by the end of the year.

Thomas Roth, senior Treasury trader at Mitsubishi UFJ Securities USA Inc., says he’s not willing to take a bullish stance on Treasuries. He thinks that the bond market is being too complacent and ignoring a risky cocktail of low coupons and high duration, a gauge of interest-rate sensitivity.

"People feel comfortable because they feel the terminal rate will be low," meaning the Fed won’t raise rates as high as it did in previous cycles, Roth said from New York. "That may happen, but it’s not a bet I’d be willing to make."

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