Fed Dots Don't Connect for Bond Traders Scorning Rate-Hike Path

Is the Market Underestimating the Fed?
  • Officials' `dot plot' forecasts seen falling by quarter-point
  • Futures priced for shortest tightening cycle in decades

The derivatives market is sending unprecedented signals that the Federal Reserve is mistaken in its policy-rate path.

Even as officials argue that higher borrowing costs are warranted, the bond world sees the potential for the shortest cycle of rate increases in almost two decades. At one point last week, traders saw the Fed as more or less done after December’s liftoff, a stance that Deutsche Bank AG calls unheard of after tightening has just begun. There’s a similar aberration in how derivatives imply the Fed target will barely budge for two years, something typically seen only before central-bank stimulus, TD Securities Inc. says.

Bond traders are losing confidence in policy makers as markets convulse and economic growth slows. In the span of a few months, traders shifted from pondering multiple increases in 2016 to a Fed on hold, while slashing market-implied inflation measures to the weakest since the recession. If history is any guide, the Fed will lower its rate forecasts at its March meeting. The move won’t be enough for traders, whose pessimism toward the economy contrasts with the Fed’s view that risks to growth and inflation are transitory.

“The Fed grudgingly has been following the market lower, and that will continue in March,” said Joseph LaVorgna, chief U.S. economist in New York at Deutsche Bank, one of the Fed’s 22 primary dealers. “Ultimately, the market will be right. The Fed is losing credibility on inflation.”

Fed’s Move

While traders can reverse their positioning quickly, they’ve been right for two years in signaling that the Fed’s projected policy path was too high. The bond market indicated even in early 2014 that the dot plot, as the Fed’s rate forecasts are known, was off by as much as one percentage point. Policy makers have spent the past year and a half cutting their outlook. Yet they haven’t caught up with investors, whose concern about the economy has only deepened. That bearishness has been rewarded: Treasuries maturing in more than a decade have earned more than 6 percent this year, Bloomberg bond indexes show.

At its March 15-16 gathering, the Fed will unveil fresh forecasts. In the past six quarterly releases, officials lowered their median federal funds projection for at least one of the coming years. In December, the median for 2017 fell to 2.38 percent from 2.63 percent. The 2016 year-end figure held at 1.38 percent, suggesting four quarter-point increases this year. Officials also estimated that their long-run target rate will settle at 3.5 percent, while derivatives indicate a level below 2 percent.

The Fed will probably cut its rate projections by a quarter-point next month, leaving it forecasting three increases this year, according to LaVorgna. Deutsche Bank predicts one increase in 2016, in December.

In the futures market, traders see about a 54 percent chance that the Fed will lift rates by December, assuming the next boost is by a quarter-point. That probability is up from below 20 percent at one point this month. At the end of last year, before the market volatility of the past two months, it was above 90 percent.

Market Divide

The divide between traders and the Fed is evident in the market for overnight index swaps, which are based on expectations for the fed funds effective rate. The contracts imply the rate will rise to only about 0.9 percent in three years from 0.37 percent now, and remain under 2 percent for a decade.

“Historically, the market hasn’t sustained this type of outlook without some kind of Fed quantitative easing” through debt purchases, or forward guidance on rates, said Gennadiy Goldberg, an interest-rate strategist in New York at TD, another primary dealer. “People are making the bet that the odds of a downturn in the economy are a lot higher than the Fed sees.”

TD predicts two rate boosts this year, which would mean traders are being too aggressive in pricing out increases.

If the Fed did stop where derivatives pricing has implied this month, it would be the first one-and-done tightening cycle since 1997. Traders anticipated more rate increases at the time, only to see the Fed pause and then reverse course after the Asian currency crisis and Russian debt debacle. Treasuries earned 9.6 percent that year, Bank of America Merrill Lynch data show. U.S. bonds due in a year or more have returned about 2 percent this year, Bloomberg bond indexes show. 

Inflation Pickup

St. Louis Fed President James Bullard said last week that a January increase in core prices showed policy makers’ forecast for quicker inflation was on track. He was referring to the 2.2 percent annual gain in the consumer-price measure that excludes food and energy costs.

The pace of inflation has been below the central bank’s 2 percent goal since 2012, according to the personal consumption expenditures price index targeted by the central bank. The measure rose 1.3 percent in January from a year earlier, data showed Feb. 26.

Inflation may be stronger than U.S. debt markets indicate, said Richard Clarida, New York-based global strategic adviser at Pacific Investment Management Co. Inflation-linked Treasuries signal about a 1.4 percent annual inflation rate for the next decade, up from as low as 1.12 percent this month as oil rebounded.

“Market pricing has probably overshot,” in terms of the Fed, Clarida said. “We’ll probably get more priced in.”

Policy makers are grappling with signs of cooling global growth and the volatility that’s seized markets periodically since early January. The upheaval began just weeks after officials raised their benchmark rate by a quarter-point from near zero, where it’d been since 2008. Minutes of their January meeting, released Feb. 17, show most were uncertain whether the turmoil would persist and affect the condition of the economy.

“The Fed effectively went on hold at the January meeting,” said Robert Tipp, chief investment strategist in Newark, New Jersey, for Prudential Financial Inc.’s fixed-income division, which manages $575 billion.

Demand for Treasuries has risen this year as negative yields in other major economies made U.S. debt more attractive. Benchmark 10-year Treasury yields touched 1.53 percent this month, the lowest since August 2012, and were about 1.73 percent Monday in New York.

With the Fed likely to lift rates only slowly and other central banks adding stimulus, Treasury yields will probably remain low, Tipp said. Benchmark five-year yields, at about 1.21 percent, may fall to near 1 percent or even below, he predicted.

“The bond market has been way ahead of the Fed for a long time in terms of saying the central bank will do a fraction of the tightening relative to what the Fed itself has signaled it will do,” Tipp said.

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