US rate traders dust off their playbooks

Another US football season has begun, and like quarterbacks and coaching staff, interest rate traders are also dusting off their trusty set of playbooks.

For a long time market volatility, related to when the Federal Reserve may start normalising short-term interest rates, has been dormant. But now, the long off-season for bored rate traders and their brethren in the trading pits of Chicago has shown signs of finally ending ahead of next week’s Fed policy meeting.

In recent days the policy sensitive two-year Treasury note yield has touched a high of 0.57 per cent, a mark not seen since May 2011. The dollar has harnessed further upward momentum, putting pressure on commodities, while equities are spinning their wheels just south of record territory.

These market moves reflect traders anticipating a higher risk that the Fed may alter its current policy language and shift from saying near zero rates will remain in place for a “considerable time” once quantitative easing ends in October.

Such terminology matters greatly for investors, who generally believe this “considerable time” entails a delay of at least six months before rate hikes begin.

While many in the bond trading community downplay the likelihood of the Fed altering this phrase as soon as next week, they are on guard for such a shift that would spark speculation of a rate increase coming next March rather than the current forecast of mid-2015.

“Our sense is that to the degree people are saying September, they’re probably jumping the gun,” says David Ader, strategist at CRT Capital. “October, of course, is the last meeting before QE ends and so has relevance, but December really puts the heat on.”

That appears a likely timetable, but rate traders are restless after being on the sidelines for a long time. Rousing the market’s animal spirits this week was a paper from the San Francisco Fed, which looked at ‘Assessing Expectations of Monetary Policy’ and made the observation that the bond market does not agree with the central bank’s higher forecasts for overnight interest rates during 2015 and 2016.

For example, while the FOMC expects a funds rate of 1.2 per cent by the end of 2015, Fed funds futures reflect a rate of 0.76 per cent.

Such a divergence between markets and FOMC forecasts has been evident for some time. Bond traders believe Janet Yellen is less hawkish and, moreover, that her views matter far more than other policy makers who think rates should normalise at a faster pace. Echoing George Orwell, some dots are more equal than others is the general view of the bond market.

Also, once the Fed does start the process of raising rates, it may keep Fed funds in their current band of moving up and down inside a range of 25 basis points. In effect creating a moving target for future overnight borrowing levels set by the central bank and making it harder for the market to ascertain a fixed target so far in advance.

But there is a danger that the FOMC’s forecasts are closer to the mark than the bond market. Under the scenario of faster-than-forecast rate hikes by the Fed the risk rises of a disorderly repricing in short-term bonds that would hit many portfolio managers and could damage the broad economy.

Beyond technical considerations, this week’s flurry of debate and rate trading reflects a foretaste of what stands to unfold as Fed communications and policy enter the post-QE phase.

John Brady, a managing director at RJ O’Brien, says the San Francisco Fed paper certainly fired up the rate-normalisation discussion and trading activity this week. It also entails a warning for all.

“In short, the paper reads like a large public disclaimer to us: mistakes may be made in the attempted normalisation of front-end rates, and it may become disruptive, but we [Fed officials] warned of this in our SF Fed paper of Sept 8.”

As football often reveals, a fumble of the ball can be a game changer for a team on the scoreboard. In that respect, the path towards the normalisation of interest rates means both traders and the Fed face a testing period with volatile swings in sentiment back in play.

michael.mackenzie@ft.com