OK, now it's time to stop betting against the Fed ........

Thursday 10th December 2015

OK, now it's time to stop betting against the Fed ........

Ref : "JPMorgan, Goldman See Bond Traders Hubris Ending in Tears", Bloomberg Markets Dec 7th 2015

Next week the US Federal Reserve is expected to finally begin the process of "normalizing" interest rates by raising the cost of Fed Funds by 25 basis points. Futures markets may suggest that the probability of a hike is a touch over 80%, but it feels even more certain than that. Surely only a major cataclysmic event between now and Dec 16th could derail a move, and the recent public utterances of Fed officials from Chair Janet Yellen downwards have only served to reinforce that view. So it's an interesting time to acknowledge the curious and slightly disturbing fact that bond traders prone to taking the Fed's view on interest rates with a hefty pinch of salt would have had a pretty good time of it over the last few years.

Pretty much since the end of the financial crisis, the Fed has consistently warned of the likelihood of borrowing costs having to rise from the historically low levels of the time and yet over the last 5 years the yield on the 10yr US Treasury has fallen from about 4% to 2.25%. Even this year when there have been opportunities to hike rates, action has been postponed. It's not as though the Fed didn't have its reasons for holding fire but it contributed to the perception that the central bank's actions are generally less decisive than its words.

Whatever the arguments one might be tempted to offer in the Fed's defence, it's hard to argue with the fact that UNDERestimating  their actions has served traders pretty well. But now, say a raft of Wall St's top names, continuing to do so could see traders catching a nasty cold. JPMorgan, Chase and Goldman Sachs are all of the view that continued growth in the US and a largely unexpected pick-up in inflation (due to higher wage pressures and lower commodity prices falling out of year-on-year calculations) mean that traders ought to be in no doubt about the Fed's determination to act boldly in the future.

Historically, the markets underestimate the extent of future tightening at the start of the cycle, and this time may prove to be no exception. Futures markets signal three, 25bp rises between now and a year's time  --  less than the Fed's forecasts and markedly less than the total of 5 hikes that some of the big boys are suggesting. Of course, their views do require making some assumptions about growth and inflation (particularly with oil prices under the cosh again) but the stakes could barely be higher should traders who have profited from the Fed taking the "easy" path in the past become complacent about them continuing to do so in the future. The global $100 trn bond market hangs on what happens in the States, where the $13.1 trn US Treasuries market took a bit of bit of caning last week merely because the European Central Bank, in easing policy once again, declined to do so quite as aggressively as some had predicted. Imagine the possible carnage should the markets have seriously misjudged the Fed's resolve to stamp on any unwanted inflationary pressures as they appear.

It's just one possible scenario of course, and as we said it seems odd to be talking about growing inflation with oil on another down-leg. But that's kind of the point ..... it's always the unexpected that has the most impact. They can't say that they haven't been warned, though whether years of watching the Fed "cry wolf", as they might see it, means that they'll be disinclined to take the dangers seriously enough is another matter.