Friday, February 24, 2012

Those believing the Fed is on hold for the next 3 years will be in for a rude awakening

Misconceptions still persist that the Fed is on hold with respect to rates until at least late 2014.
WSJ (Feb 16th): ... They said after their last meeting in January they expect to keep rates at "exceptionally" low levels until late 2014.
The markets would disagree. The Fed Funds futures have the first rate hike (25bp) centered around August of next year and the second hike (to 50bp) on July of 2014.

Fed Funds Futures (implied rate) expected rate hike dates

The market has completely reversed the Fed's announcement on January 25th. In fact the expectations for the first hike are now even earlier than they were before the Fed's statement.

Fed Funds Futures  (implied rate) expectations of rate hike shifted to an earlier date than was priced in before the Fed's announcement

The market is fully ignoring the FOMC's prolonged zero rate forecast. If Bernanke tried to lower short-term rate expectations by the announcement, he failed miserably (though it's possible that was not his intent), as the rate expectations are now even higher than prior to the announcement. Why is the market pricing in higher short-term rates (an early rate hike)? The answer has to do with relatively strong economic data coming out of the US and rising commodity prices. All of this is driving up inflation expectations. The chart below shows TIPS implied 2-year forward inflation expectation now comfortably above 2%, the Fed's inflation target.

TIPS implied 2-year forward (breakeven) inflation expectation

The market is prepared for the first rate hike in about 16 months, possibly sooner. Those who are becoming complacent believing the Fed is on hold for the next 3 years will be in for a rude awakening.
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