Bond Market Signals It May Be Ready to Take the Fed at Its Word

  • Yield curve flattens most in ‘16 for policy announcement week
  • Officials still have work to do to get traders on board

Treasuries traders are signaling a growing conviction that the Federal Reserve will follow through on its projections and raise interest rates in 2016.

One measure of the yield curve -- the extra yield investors demand on 30-year bonds over two-year notes -- shrank nine basis points this week, to about 1.6 percentage points. That’s the sharpest drop this year during the week of a Fed policy announcement. A flatter curve can indicate traders are favoring longer maturities because a potential Fed hike is seen as restraining inflation, preserving the securities’ fixed payments.

Policy makers still have work to do to get investors on board with a hike in 2016, following liftoff from near zero in December. Even after the Federal Open Market Committee’s statement Wednesday that “the case for an increase in the federal funds rate has strengthened,” futures markets imply less than a 60 percent chance of a quarter-point hike by year-end.

“The market is finally taking the Fed at their word and setting up for the possibility of a rate hike later this year,” said Gennadiy Goldberg, an interest-rate strategist in New York at TD Securities (USA) LLC, one of the Fed’s 23 primary dealers. “The market is finally thinking the Fed might go.”

Yields on two-year Treasuries, the coupon maturity most sensitive to Fed expectations, fell about one basis point, or 0.01 percentage point, this week to 0.75 percent, according to Bloomberg Bond Trader data. 

Catching Up

That’s the worst performance this year in the week of a rate decision, suggesting traders were reluctant to brush off the message that a hike may be ahead. In the previous five policy-announcement weeks this year, the two-year yield dropped seven basis points on average. Two-year notes may also be underperforming as the Treasury is scheduled to auction $26 billion of the maturity next week.

Helping fuel bets on a rate boost, three policy makers dissented from the majority decision to hold rates steady even amid progress in the labor market, expectations for higher inflation and calm in global financial markets. Officials’ median projection for the path of rates, known as the “dot plot,” is for one quarter-point hike this year and two in 2017. In June, they forecast raising rates three times next year.

"The dots are catching up with the market, not the market with the dots," said Andres Jaime, a foreign-exchange and rates strategist in New York at Barclays Plc, another primary dealer. "Markets believe the central bank wants to hike once this year."

The market-implied probability of a hike this year is 55 percent, according to futures data compiled by Bloomberg. That’s 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. A month before the 2015 rate hike, there was a 66 percent chance of an increase priced in.

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