Derivatives Show Traders Are Undeterred on Rates by FOMC Minutes

Derivatives show minutes from the Federal Reserve’s last meeting did little to alter traders’ expectations that policy makers will begin raising interest rates this year. That's where the similarities on the outlook for rates between the bond market and the central bank ends.

Federal funds futures show a 59 percent chance of the Fed raising its near-zero policy rate in September, little changed from before the release of the Dec. 16-17 meeting minutes. For the years ahead, traders see the Fed increasing rates to only about half the 3.75 percent peak level policy makers predict.

Long-term Treasury yields have plunged to almost record lows since the Fed’s policy meeting last month as oil prices tumbled and the risk of deflation in the euro zone rose. The 10-year Treasury note yield at 1.96 percent is close to the 1.6 percent level that held at the start of May 2013, before the so-called taper tantrum, when then-Fed Chairman Ben S. Bernanke surprised markets by appearing to signal an imminent reduction in the pace of the central bank’s bond purchases.

“Given the decline in inflation expectations, the strength of the dollar and market movements in recent weeks, there is a group of people that doubt that the Fed will be able to execute the path for rates that they have laid out,” said Michelle Girard, chief U.S. economist at Royal Bank of Scotland Group Plc’s RBS Securities unit in Stamford, Connecticut, before the minutes were published. The firm is one of 22 primary dealers that trade with the Fed.

“This is more about inflation than the economy in terms of the path for rates and even the timing of the first hike,” said Girard, who aligns with the Fed and expects the funds rate to peak in 2017 at 3.5 percent. “The U.S. growth numbers have really checked all the right boxes.”

Normalization Process

Most Fed officials agreed their new policy guidance means they are unlikely to raise interest rates before late April, and a number expressed concern inflation could remain too low, the minutes showed.

“Most participants thought the reference to patience indicated that the committee was unlikely to begin the normalization process for at least the next couple of meetings,” according to the Federal Open Market Committee meeting minutes released today in Washington.

Fed officials last month lowered where they see the funds rate rising to at the end of 2015, with the benchmark rate moving to 1.125 percent, compared with a 1.375 percent median estimate in September, according to quarterly estimates from U.S. central bankers released on Dec. 17. The rate will be 2.5 percent at the end of 2016, and 3.625 percent at the end of 2017, according to median estimates.

Futures Speculation

Eurodollar futures, which are priced at expiration to the three-month London interbank offered rate and used to speculate on Fed policy changes, signal the funds rate will be at about 1.9 percent at the end of 2017. Fed fund futures, which settle to the average of the effective rate over the life of the 30-day contract, show the policy rate moving to 0.57 percent by the end of 2015 and 1.4 percent a year later.

The central bank has kept its target for the federal funds rate in a range of zero to 0.25 percent since 2008 to support economic recovery from the worst recession in seven decades.

While economic growth has picked up, inflation has held below the Fed’s 2 percent goal for more than two years. Sliding commodity prices and renewed risk that Greece may drop out of the euro area has added to a drop in risk of prices pressures. Consumer prices fell 0.2 percent in the euro-area in December, the first decline in more than five years, data showed.

Inflation Outlook

The 10-year break-even rate, a measure of inflation expectations, touched today the lowest level in almost five years. The difference between yields on 10-year notes and similar-maturity TIPS dropped touched 1.54 percentage points, the least since September 2010.

The U.S. benchmark for crude-oil futures reached $46.83 today, about a 57 percent decline from its June high and the lowest since April 2009.

A stronger greenback reduces price pressures in America as it makes goods imported from abroad cheaper. Intercontinental Exchange Inc.’s U.S. Dollar Index, which tracks the currency against six major peers, rose 0.5 percent to 91.955 after climbing to 92.265, the highest level since December 2005.

“Nobody disagrees with the Fed’s timing of rate increases beginning sometime this year, but there is disagreement over the ultimate trajectory for rates,” said Kenneth Silliman, head of U.S. short-term rates trading in New York at Toronto-Dominion Bank’s TD Securities unit, a primary dealer, in a telephone interview. “That is where the tug of war is happening. The Fed’s projections for rates seem to be too optimistic given what’s going on in the world.”

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