Despite immense pressure on early morning futures following a global sell-off, the S&P 500 ended up rallying to its 2nd best day of the year. Markets grinded higher throughout the day as interest rate yields dropped and the yen weakened back to 95.11 from the 94 handle. The last 30 minutes were particularly explosive, as Fed reporter Jon Hilsenrath put out an article indicating that next Wednesday’s all important FOMC press conference will be very dovish. According to the report, Fed Chief Ben Bernanke will stress that any move to reduce the pace of quantitative easing won’t mean the Fed is close to ending the program. On that news, the 10 year yield dropped all the way down to 2.129 percent from 2.20 earlier in the day, catapulting both bonds and equities higher.
Analysis: Fed Likely to Push Back on Market Expectations of Rate Increase
Federal Reserve officials have been trying to convince investors for weeks not to overreact when the central bank starts pulling back on its $85 billion-per-month bond-buying program. An adjustment in the program won’t mean that it will end all at once, officials say, and even more importantly it won’t mean that the Fed is anywhere near raising short-term interest rates.
Investors aren’t listening.
A wide range of indicators suggest that investors are starting to think the Fed might start raising short-term interest rates — now near zero — sooner than previously thought. Until recently many market indicators suggested investors expected the first rate increases in mid-2015, but now these indicators indicate investors think it could be sooner.
Prices have been dropping in Eurodollar and fed-funds futures markets, for example, where investors make bets on future short-term interest rates. Those declines suggest investors expect higher short-term rates by late 2014. In the fed-funds futures market, for example, the expected fed funds rate in December 2014 is 0.35%. In the Eurodollar market, investors see 3-month rates borrowing rates rising to 0.67% by December 2014.
A similar message is coming from swaps markets, where the market is pricing in an average 0.37% fed funds rate between June 2014 and May 2015, according to BNP Paribas. That is up from an expected rate of 0.17% in early May.
The fed funds rate — which is an interbank borrowing rate — was 0.08% yesterday.
These movements aren’t huge and could quickly reverse, but they merit attention.
There are three possible explanations for the movements in expected short-term rates:
1) Money markets are out of whack for technical reasons.
2) The market is pricing in a stronger economy, which it in turn expects to prompt Fed rate increases.
3) Investors are starting to doubt the Fed’s commitment to keep short-term rates down.
Many market participants say it is the latter. “The market is saying, ‘The fundamental economic outlook really hasn’t changed much, but we are getting more worried about Fed policy,’” says Jan Hatzius, chief economist at Goldman Sachs.
Since last December the Fed has been promising to keep short-term interest rates near zero until the jobless rate reaches 6.5%, as long as inflation doesn’t take off. Most forecasters don’t see the jobless rate reaching that threshold until mid-2015.
At the same time, however, the Fed is talking about pulling back on its $85 billion-per-month bond-buying program. The chatter about pulling back the bond program has pushed up a wide range of interest rates and appears to have investors second-guessing the Fed’s broader commitment to keeping rates low.
This is exactly what the Fed doesn’t want. Officials see bond buying as added fuel they are providing to a limp economy. Once the economy is strong enough to live without the added fuel, they still expect to keep rates low to ensure the economy keeps moving forward.
It’s a point Chairman Ben Bernanke has sought to emphasize before. The Fed, he said in his March press conference and again at testimony to Congress last month, expects a “considerable” amount of time to pass between ending the bond-buying program and raising short-term rates.
He seems likely to press that point at his press conference next week, given that the markets are telling him they don’t believe it.