NEW YORK (Reuters) - Short-term interest rate traders are bracing for the possibility the Federal Reserve could begin raising interest rates later this year, even though many economists don’t see the Fed moving any time soon.
The traders’ view of a possible rate hike has been embedded in short-term U.S. interest rate futures since mid-March on increased optimism of an economic turnaround and the start of a spring rally on Wall Street, although this week’s weaker-than-expected data has tempered the view.
Adding to the expectations of tighter Fed policy is the weight of the some $2 trillion in new U.S. government debt supply aimed to finance the Obama administration’s stimulus and bailout programs.
“The market has priced in a rate hike by the end of the year,” said Rudy Narvas, senior strategist with 4Cast Ltd. in New York.
Traders who are betting on a Fed hike later this year believe nascent signs of economic stability, rising commodity prices and $2 trillion of new U.S. government debt this fiscal year will force the Fed to tighten monetary policy earlier than the consensus view.
On Thursday, Eurodollar futures implied traders are pricing in the likelihood the Fed could raise its policy rate by a quarter percentage point to about 0.50 percent by the end of 2009, analysts said.
SUPPORTING INDICATORS
Other forward rate measures, like the Overnight Indexed Swap rates, also signal the money market is anticipating the Fed could tighten monetary policy earlier than most private economists are forecasting.
OIS rates that gauge the market’s anticipated Fed policy rate nine months and 12 months from now were running at 0.28 percent and 0.36 percent, respectively, well above the Fed’s current target range.
These expectations match those voiced earlier this week by John Taylor, a former top U.S. Treasury official.
Taylor, who spoke at a conference sponsored by the Atlanta Fed on Tuesday, said his own figures show the current Fed policy is far too loose.
“My calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate,” said Taylor.
The view contrasts with the outlook of most economists who predict the Fed will not remove its near-zero interest rate policy until 2010 at the earliest. In a Reuters poll conducted last week, six of 11 Wall Street economists said the Fed’s rate increase would occur only after 2010.
Morning commuters drive past the Federal Reserve Bank building in Washington March 18, 2009. REUTERS/Jonathan Ernst
Wednesday’s weak retail sales data served as a stark reminder the worst U.S. recession in decades may not end any time soon. Thursday’s tame Producer Price Index reinforced the notion the Fed’s immediate battle is to stem the damaging impact from deflation, not inflation.
In addition, analysts noted the fragile banking system and sluggish credit demand will likely persist as drags on the economy, keeping a lid on inflation and countering any urgency for the Fed to hike rates.
“It’s a premature view of potential inflation and a Fed rate hike,” said Alex Roever, short-term rate strategist at J.P. Morgan Securities in New York.
Still, the fear of inflation expressed in short-term rates has been echoed by at least one current Fed policymaker.
Last week, Richmond Fed President Jeffrey Lacker said the Fed will need to pare back its ballooning balance sheet to prevent a spike in inflation. He added he personally believed the risk of deflation was overstated and the U.S. central bank should be vigilant to curb inflation expectations.
Reporting by Richard Leong; Editing by Kenneth Barry
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