Bonds on Collision Course With Fed
December is a great time to take a vacation. It is a terrible time for the Federal Reserve to raise interest rates.
The most obvious reason is because, well, many people go on vacation and are therefore out of the office. Why would the Fed want to wreak havoc on their time off? And think of the hardworking souls left in the office; they’d have to deal with the messy aftermath of the first interest rate increase in almost a decade, which would surprise much of the bond market.
The less obvious, yet more salient reason is that December is when banks tidy up balance sheets, strip down risk, close out books and prepare for a final year-end stress test by regulators. That means traders at big banks aren’t going to be as willing to facilitate big Treasury and other debt transactions, leading to bigger price moves if the Fed acts.
For those who doubt how much volatility this can cause, RBC Capital Markets strategists reviewed the several times this year, such as the period around Sept. 30, when big banks pared their holdings ahead of regulatory surveillance and end-of-quarter earnings reports. In that period, relative yields on U.S. corporate bonds soared to the highest level of 2015 and then retreated again within just days without a fundamental explanation.
“It was simply a result of illiquidity," wrote RBC strategists Michael Cloherty and Dan Grubert in a report this week. “We would all be calling the Sept. 30th move a flash crash if it had happened in a single day.”
December will most likely produce an even worse environment in terms of potential price swings. Not only will banks be preening for regulators, but investors will be hunkering down, licking their wounds or locking in any victories. That leaves few daring traders left to catch a falling knife, if one should fall.
The Fed will consider the interest rate question again on Wednesday, but an increase is all but off the table, with futures traders putting the chance of a move at 4 percent, according to data compiled by Bloomberg. They’re pricing in less than a 40 percent chance of an increase in December.
There are arguments on both sides of the question. For those in favor: The unemployment rate is low again. It has been almost seven years since the Fed bottomed-out the rate. Zero-rate policies just penalize prudent investors who save up for the future. For those against: Inflation is nonexistent. The economy isn’t going gangbusters. Every other central bank that matters is headed in the other direction.
Insert into the debate timing and market disruption. If the Fed decides to pull the trigger in December, debt market participants better buckle up.
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