Goldman Flags $1 Trillion Reason for Fed to Go Slow on Rates
June 4, 2016
Futures imply practically no chance of rate boost this month
Election timing means some analysts rule out Sept., Nov.
For bond traders, the stalling U.S. job market means the Federal Reserve will probably lift interest rates just once this year, in December.
The nation’s employers added workers at the slowest pace in almost six years in May, government data showed Friday. The report fueled a surge in Treasuries, driving yields on two-year notes down the most since September and all but erasing bets on a rate increase at the Fed’s June 14-15 meeting.
Though central bankers have signaled that the following gathering, in July, might also be in play, derivatives traders are dubious of that timing as well. The market-implied probability of a July boost dropped by about half Friday, to below 30 percent. For the following meetings, the U.S. presidential election starts to enter the mix. Some traders are looking past the September and November gatherings, in a wager that policy makers won’t want decisions on rates to get caught up in electoral politics.
“The Fed will certainly, through speeches, try to keep July in play,” said Scott Buchta, head of fixed-income strategy at Brean Capital LLC in New York. “They are still data-dependent, but I don’t know how likely they will be to raise rates too close to the presidential election. So there is a shot we get one more hike this year, but it’s not quite a done deal.”
The probability of a quarter-point hike in June plunged below 5 percent Friday, from 22 percent June 2, data compiled by Bloomberg show. It was 30 percent a week ago, after Fed Chair Janet Yellen said officials will raise rates "probably in the coming months" as they look for evidence of labor-market strength and a pickup in inflation.
It isn’t until December that traders assign greater than a coin-flip probability to a hike: Futures indicate about a 60 percent chance.
The addition of 38,000 workers last month, the smallest gain since 2010, was less than the most pessimistic forecast in a Bloomberg survey.
Shallow Path
The report also led traders to price in fewer Fed hikes for the years ahead. In two years, the effective fed funds rate will probably rise to just 0.83 percent, from 0.37 percent now, according to Bloomberg data using overnight index swaps. That implies less than two quarter-point increases to the Fed’s range in that period.
In their latest quarterly projections, Fed officials in March cut their forecasts for 2016 rate increases to two from four, after liftoff from near zero in December.
Most strategists aren’t ready to fully dismiss a July tightening, if certain conditions are met. one is that economic data need to signal job-market strength. The second is that financial markets must get past the U.K.’s June 23 referendum on European Union membership, dubbed Brexit.
“July could still happen if payrolls come around next month, positive data continues and depending on what happens with Brexit,” said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald LP, one of the 23 primary dealers.
Beyond that, “it would be a really hard sell for the Fed to potentially raise rates ahead of what could be a very heated election,” he said. “If you didn’t have the election, the percentages would be a lot higher for September.”
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Goldman Flags $1 Trillion Reason for Fed to Go Slow on Rates
June 4, 2016 — 3:48 AM JST
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Jump in Treasury yields may hurt bondholders more than crisis
‘Significant distress’ seen with central bank tightening
Lurking in the bond market is a $1 trillion reason for the Federal Reserve to go slow on interest-rate increases.
That’s how much bondholders stand to lose if Treasury yields rise unexpectedly by 1 percentage point, according to a Goldman Sachs Group Inc. estimate. A hit of that magnitude would exceed the realized losses since the financial crisis on mortgage bonds without government backing, Goldman Sachs analysts Marty Young and Charles Himmelberg wrote in a note published today.
“Some investor entities would likely experience significant distress,” Young wrote. “Rising yields should be on the short list of scenarios to be monitored by risk managers.”
Money managers have embraced securities with longer maturities as record low interest rates around the world fuel a search for yield. Trouble is, when interest rates rise, bond prices fall -- and longer-term debt gets hit hardest.
Investors have been buying longer-term bonds while the market has grown and interest payments have fallen. That means potential losses from rising rates are higher, and the income investors receive from bonds will do less to insulate them from the pain of having principal tied up at lower rates, Goldman Sachs warns.
Stubbornly Low
The Fed started tightening rates in December, when it raised its main borrowing rate for the first time in more than a decade.
The median forecast in a Bloomberg survey is for 10-year yields to climb to 2.6 percent by the third quarter of next year, from about 1.7 on June 3. New York-based Goldman Sachs sees rates advancing to 3.3 percent by 2018.
Analysts and regulators have warned for months that rising rates will be painful for investors and lenders, but bond yields remain stubbornly low. The benchmark 10-year Treasury note yield dived the most in more than a year Friday after the monthly U.S. payrolls report showed employers added the fewest number of workers in almost six years. That may derail Fed plans to raise borrowing costs in the coming months. Policy makers next meet June 14-15.
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