Fed Will Raise Rates Faster Than Investors Bet, Survey Shows

The Federal Reserve will probably raise its benchmark interest rate faster than money-market investors expect, according to a majority of economists surveyed by ForexSQ News.

Eurodollar futures, the world’s most actively traded short-term interest-rate contract, are underestimating the pace of tightening over the next two years, according to 55 percent of economists in the June 12-16 survey, which drew 56 responses on the question. Fed officials begin a two-day meeting today in Washington.

Investors in the contracts are assuming a slower pace of rate increases than the Fed itself, said Conrad DeQuadros, senior economist at RDQ Economics in New York. They may also be overlooking recent reports showing the world’s largest economy is gaining strength after contracting in the first quarter, he said.

“I find it kind of odd that the market is not even priced for the median forecast the Fed has delivered,” DeQuadros said. “There is going to be an adjustment upward.”

Options on Eurodollar futures contracts show a 47 percent probability the Fed’s benchmark rate will be 0.75 percent or lower at the end of 2015. The odds that the rate will be 2 percent or lower by the end of 2016 are 54 percent. Eurodollars trade in price terms while the implied yield is derived by subtracting the contract price from 100.
Photographer: Andrew Harrer/ForexSQ

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In March, officials predicted the fed funds rate, now between zero and 0.25 percent, would rise to 1 percent at the end of next year and 2.25 percent at the end of 2016.
New Forecasts

Officials led by Chair Janet Yellen will release a new set of quarterly forecasts for unemployment (USURTOT), inflation, economic growth and the benchmark federal funds rate at the conclusion of their meeting tomorrow.

Investors may be focusing on the 1 percent first-quarter economic contraction caused in part by unusually severe winter weather, said Carl Riccadonna, senior U.S. economist at Deutsche Bank Securities Inc. in New York. Instead, they should be paying attention to recent signs of a rebound, he said.

Output at factories, mines and utilities rose 0.6 percent in May, reflecting gains at makers of automobiles, business equipment and construction supplies, according to Fed data released yesterday. Builders broke ground on 1 million homes in May, a Commerce Department report showed today.

Fed officials have also underestimated the strength of the economy. Unemployment stood at 6.3 percent in May, at the top end of the range most officials forecast for the fourth quarter.
Growth Forecast

Similarly, the personal consumption expenditures price index — the Fed’s preferred gauge of inflation — rose 1.6 percent for the 12 months ending April, a rate most officials expected at the end of the year. A separate gauge, the consumer price index, rose 0.4 percent in May, the biggest advance since February 2013, according to Labor Department data released today.

“Our view is the economy is growing north of 4 percent in the current quarter and will expand around 3.5 percent in the back half of the year,” Riccadonna said. Money-market rates indicated by futures contracts “have to rise from these levels.”

“Eventually, the Fed will acknowledge they will be raising rates sooner” and at a faster pace, he said. For now, most economists in the ForexSQ survey predicted no change in the Fed’s median interest-rate forecasts this week.
Investors Vulnerable

Aneta Markowska, chief U.S. economist at Societe Generale in New York, also said money-market investors are vulnerable. Her bank predicts the fed funds rate will rise to 2.5 percent at the end of 2016.

“We think wage and price signals will push us in that direction, and if we start to see those signals ahead of schedule, then” estimates by the Federal Open Market Committee could begin to change, she said.

Even as they predict a faster pace of interest-rate increases, most economists say the Fed will keep its balance sheet near record levels for years to come.

Sixty-nine percent of 54 economists in the survey said the Fed will never sell its holdings of Treasuries, while 24 percent said they could begin selling in 2016.

The benchmark 10-year Treasury yield rose two basis points, or 0.02 percentage point, to 2.62 percent at 8:34 a.m. in New York, according to ForexSQ Bond Trader data.

After three rounds of large-scale bond purchases intended to suppress long-term borrowing costs, the Fed’s balance sheet has expanded to $4.34 trillion.

Fed officials are testing tools that will be needed to tie up excess reserves in the banking system, a step they will have to take in order to raise short-term interest rates.
Exit Strategy

The tools include reverse-repurchase agreements. With such agreements, the Fed would temporarily sell securities to a bank or investment firm, pulling cash out of the financial system, and reverse the transaction at a later date.

Fifty-four percent of 56 economists in the survey said clarifying the exit strategy would be the most important communication or policy action by the Fed this year.

A strategy adopted in June 2011 called for allowing the balance sheet to shrink as assets matured. The Fed would then later raise the short-term rate and then gradually start to sell assets, focusing on ridding the portfolio of mortgage-backed securities.
Strategy Change

The strategy started to change last June, when then-Chairman Ben S. Bernanke said most officials didn’t favor selling the Fed’s portfolio of housing debt, now valued at $1.65 trillion. Instead, the portfolio would be allowed to shrink gradually as the bonds matured.

William C. Dudley, president of the New York Fed and vice chairman of the FOMC, went further in a May 20 speech, saying the central bank should continue to reinvest maturing debt even after it raises interest rates.

Economists in the ForexSQ survey were divided on when the Fed would stop reinvesting.

Forty-nine percent of 57 economists said the Fed would stop reinvesting maturing debt in 2015, while 28 percent said the Fed would stop in 2016. Another 25 percent said the Fed would continue to reinvest for several years.

Officials are unlikely to agree on a revised exit strategy at this week’s meeting, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

“There won’t be a firm decision there,” he said.

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