Fed Stuck at Zero Into 2015 Seen in Swaps, QE Odds Reach 99%Liz Capo McCormick and Susanne Walker
Just six months ago, money market traders expected the Federal Reserve to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens.
Bond market measures from overnight index swaps, which indicate no increase in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008.
Investor expectations for sluggish growth and low inflation remain intact even though the collapse of Lehman Brothers Holdings Inc., which triggered the worst financial crisis since the Great Depression, happened four years ago. While the economy expanded in the second quarter, the unemployment rate remained above 8 percent for the 43rd-straight month in August.
“The problems have been bigger than anticipated and it will take a while to work our way through these issues,” Larry Dyer, a U.S. interest-rate strategist in New York with HSBC Holdings Plc’s securities unit, said in an interview on Sept. 6. “The bond market is pricing in pretty close to a very prolonged period of low growth,” said Dyer, whose company is one of the 21 primary dealers that trade with the central bank.
Payrolls rose by 96,000 in August, the Labor Department said Sept. 7, below the 130,000 median estimate of 92 economists in a Bloomberg News survey, and the unemployment rate was 8.1 percent. Growth slowed to an annualized rate of 1.7 percent in the second quarter from 2 percent in the first, according to the Commerce Department on Aug. 30. That compares with the 3.2 percent average increase in gross domestic product since 1950.
Bonds rallied following the report on speculation that policy makers will announce plans as soon as this week to pump more money into the economy to bolster growth by keeping yields low. For the week, 10-year Treasury yields rose 12 basis points, or 0.12 percentage point, according to Bloomberg Bond Trader prices. The yield was little changed today at 1.67 percent as of 10:52 a.m. in New York.
Fed Chairman Ben S. Bernanke said on Aug. 31 in Jackson Hole, Wyoming, that he wouldn’t rule out steps to lower a jobless rate he described as a “grave concern.”
He said additional bond purchases on top of the $2.3 trillion in so-called quantitative easing since 2008 are an option. He said past adjustments to the guidance policy makers have given on rates have been an effective way to signal policy.
“They do stand ready for more policy accommodation and that will likely take the form of an expansion of the balance sheet in longer dated Treasuries or mortgages,” Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock Inc. in New York, which has $3.5 trillion under management, said in a telephone interview on Sept. 7. He anticipates the Fed will provide more guidance on the timing of rate policy first.
The Fed lowered its target rate for overnight loans between banks in December 2008 to a range of zero to 0.25 percent.
Implied forward rates for contracts that show what traders expect the federal funds effective rate to average over a set time period in the future indicate that a quarter-percentage advance won’t come until about July 2015. Two months ago, the swaps predicted an increase by about March of that year.
Volatility as seen in the debt options market fell this quarter to the lowest levels since before the financial crisis in June 2007, the opposite of what would likely happen if traders expected the Fed to tighten monetary policy soon.
A measure of the perceived degree of future swings in swap rates, known as normalized volatility, for three-month options on 10-year interest-rate swaps, or 3m10y swaptions, touched 71.8 basis points on July 23, before ending last week at 79.7 basis points. A year ago, the reading was above 110.
If the central bank says it will keep rates lower for longer, volatility may fall toward 70, according to Jim Lee, head of U.S. derivative strategy at Royal Bank of Scotland Group Plc’s RBS Securities Inc. in Stamford, Connecticut. RBS, which is also a primary dealer, sees a 90 percent chance that policy makers will announce a new round of debt purchases.
A gauge of indicators of market expectations for additional central bank stimulus rose to a record 99 percent in August, according to Citigroup Inc. The measure increased to 82 percent in the months before QE2 in November 2010.
“The market thinks that at Jackson Hole, Bernanke was saying conditions are pretty bad,” said Neela Gollapudi, a New York-based strategist at Citigroup Inc., in a telephone interview Sept. 5. “It’s less likely that they would do QE without extending the language.”
Bond strategists and economists have reduced their yield forecasts. The median of more than 70 estimates in a Bloomberg survey published Aug. 9 found that they see 10-year yields ending this year at 1.65 percent and 2.38 percent in 2013. In the prior monthly poll they saw 1.9 percent and 2.7 percent.
Central bank action may be losing some of its punch. Currency trades designed to benefit from expectations of stronger growth as the Fed eases are instead losing money.
The so-called carry trade, where investors borrow in lower-rate currencies such as dollars to buy higher-yielding ones, has fallen 2.8 percent from a four-month high on Aug. 9, the UBS AG V24 Carry Index shows. After Bernanke signaled QE2 in August 2010, the transaction gained 3.1 percent in 30 days.
“The longer the Fed says it’s going to wait to raise rates, the less confident many investors and businesses may be on the outlook,” Joseph LaVorgna, chief U.S. economist for Deutsche Bank Securities Inc. in New York, said in an interview on Sept. 6. “That would send a negative message to people and they want to be less negative.”
Ten-year Treasury yields will end the year at 2.25 percent, according to LaVorgna, whose company is another primary dealer.
Moves by the European Central Bank to prevent the breakup of the euro allow the Fed to concentrate more on growth, Carsten Brzeski, a senior economist at ING Group in Brussels, said in a Sept. 6 interview. ECB President Mario Draghi said that day policy makers agreed to an unlimited bond-purchase program to contain rising yields in the euro area and fight speculation that Greece might leave the 17-nation currency.
“It does enable the Fed to focus more on its domestic issues: the economy, the labor market and the potential fiscal cliff,” Brzeski said, referring to tax increases and spending cuts of $1.2 trillion over a decade that would begin if Congress fails to agree by Dec. 31 on ways to reduce the deficit.
Republicans unhappy with Bernanke’s stimulus actions called for an audit of the Fed in their 2012 platform adopted in Tampa Aug. 28. Senator Bob Corker of Tennessee said in a press release Sept. 6 that an “unhealthy obsession” with monetary policy is distracting the public from the need for fiscal reform.
U.S. GDP will expand 2.2 percent this year and 2.1 percent in 2013 according to median forecasts compiled by Bloomberg. Morgan Stanley cut its 2012 global growth forecast to 3.2 percent from 3.7 percent according to an Aug. 15 report, and the ECB on Sept. 6 said euro area output will contract 0.4 percent this year, worse than the 0.1 percent it had predicted three months earlier.
Two-year Treasury yields ended last week at 0.25 percent, or 0.4 percentage point below the 0.65 percent for five-year notes. The two-year yield was 0.25 percent today. The gap has narrowed from a peak this year of 81 basis points in March as signs the recovery was slowing caused traders to expect low money market rates to persist for several years.
“What the Fed and the ECB are trying to do is damp volatility,” Bill Gross, manager of the world’s largest bond fund at Pacific Investment Management Co., said Sept. 7 in a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. “Central banks are in the business now of keeping yields low for a very long time.”
Gross said he is seeking to bolster returns by capitalizing on the likely decrease in bond price swings.
His $270 billion Total Return Fund gained 8.2 percent during the past year, beating 97 percent of its peers, according to data compiled by Bloomberg. The fund rose 0.9 percent in the past month, topping 93 percent of comparable funds.
“Nervousness and continued agony over in Europe, the fiscal cliff, election uncertainty means there are a lot of headwinds,” said Mark MacQueen, partner and money manager at Austin, Texas-based Sage Advisory Services Ltd., which oversees $10 billion. “Everything is lining up to be more difficult. The Fed will give us language that reassures the market they intend on doing more.”
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