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INTEREST RATES

US Fed tipped not to raise rates until 2015

Bond market measures from overnight index swaps indicate no rise in the federal funds rate until mid-2015 as US economy remains lethargic

PUBLISHED : Tuesday, 11 September, 2012, 12:00am
UPDATED : Tuesday, 11 September, 2012, 2:30am

Just six months ago, money market traders expected the US Federal Reserve to raise interest rates by the end of next year, but now they see them at record lows for about three more years as the economic outlook worsens.

Bond market measures from overnight index swaps, which indicate no rise in the federal funds rate until mid-2015, to a 62 per cent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer.

The gap between two-year and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 per cent narrower than its average since 2008.

Investor expectations for sluggish growth and low inflation remain intact even though it is four years since the collapse of Lehman Brothers, which triggered the worst financial crisis since the Depression. While the economy expanded in the second quarter, the unemployment rate remained above 8 per cent last month, for the 43rd consecutive month.

"The problems have been bigger than anticipated and it will take a while to work our way through these issues," aid Larry Dyer, an interest-rate strategist in New York with HSBC.

"The bond market is pricing in pretty close to a very prolonged period of low growth," Dyer, whose firm is one of the 21 primary dealers that trade with the central bank. United States jobs rose by 96,000 last month, the labour department said, well below the 130,000 median estimate of 92 economists in a survey, and the unemployment rate was 8.1 per cent.

Growth slowed to an annualised rate of 1.7 per cent in the second quarter from 2 per cent in the first, according to a commerce department report on August 30. That compares with the 3.2 per cent average increase in GDP since 1950.

Bonds rallied following the report on speculation that policymakers 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.

Fed chairman Ben Bernanke said on August 31 that he would not rule out steps to lower a jobless rate he described as a "grave concern". He said additional bond purchases on top of the US$2.3 trillion in so-called quantitative easing, or QE, since 2008 were an option. He noted that past adjustments to the guidance policymakers 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," said Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock.

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 per cent.

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 an advance was not expected to come until about July 2015. Two months ago the swaps predicted a rise 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 be likely to 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 normalised volatility, for three-month options on 10-year interest-rate 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 does say it will keep rates lower for longer, volatility may fall toward 70, according to Jim Lee, head of US derivative strategy at RBS Securities.

Royal Bank of Scotland, which is also a primary dealer, sees a 90 per cent chance that policymakers will announce a new round of debt purchases.

A gauge of indicators of market expectations for additional central bank stimulus last month rose to 99 per cent, the highest ever, according to Citigroup. The measure increased to 82 per cent in the months before the second round of quantitative easing in November 2010.

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.

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