Fed faces its trickiest rate cycle yet

Will they, won't they? That is the question being asked on trading desks and dealing floors across the financial industry, as markets grapple with whether the US Federal Reserve is still on track to raise its interest rate for the first time in almost a decade this summer.

Investors have in recent weeks markedly pared back their expectations for when and how aggressively the Fed will move, after a clutch of underwhelming economic data and dovish coos from many of the US central bank's policy makers. Last month's disappointing US jobs data stoked concerns about the economic recovery and led to a further muting of rate hike bets.

At the start of the year at least two quarter-point hikes were priced into futures markets, with the risk of a third towards the tail-end of 2015. Futures now imply that the Fed will probably only raise interest rates once this year, and will only start this autumn rather than in June. The market is even pricing in a chance that the US central bank sits on its hands throughout 2015.

"If they were indeed data-dependent then they aren't going to move," argues Kevin Giddis, head of fixed income at Raymond James. "The data doesn't support raising rates in June, September or even December for that matter. We're looking at a slow economy with very low inflation, so I just cannot see how they can move."

Nonetheless, some money managers and analysts are far from convinced that a June interest rate increase is off the table. While Fed futures have sagged, the dollar and US Treasury yields have reversed their post-payrolls dives and are now trading at roughly where they were before the data release.

The fact that the Fed could still move in June was brought home by the release on Wednesday of minutes from the last central bank meeting. While economic forecasts were lowered at that meeting, the minutes revealed that "several" policy makers favoured an initial rate increase in June, with some concerned that keeping rates at zero when the economy is growing at a respectable clip risked inflating financial market bubbles.

The last Federal Reserve meeting took place before the release of last Friday's non-farm payrolls, but some analysts argue that one unexpectedly poor, probably weather-affected jobs report after a string of robust readings was unlikely to rattle Fed policy makers too much.

Some influential money managers agree. On a conference call with investors on Tuesday, Jeffrey Gundlach, the head of asset manager DoubleLine, said that while there had been a "litany" of bad economic releases of late, some of the more instantaneous real-time data was more encouraging. "All bets are not off for a June hike," he told the call. "The Fed seems philosophically keen to hike rates."

Still, other money managers urge caution. Michael Kushma, chief investment officer for fixed income at Morgan Stanley's asset management arm, argues that even if the headline jobs numbers pick up in the coming months, many other labour market measures have long been underwhelming.

"Patience is a virtue," he says. "Why not play it by ear and wait to see more data. I'd go before the end of the year, but there's no rush."

One reason to hold fire is the strength of the US dollar. Although its rally has fizzled in recent weeks, the greenback's rise has already begun to hurt corporate earnings and several Fed officials fret that it could curtail US exports and economic growth, according to the latest minutes.

Larry Fink, the head of BlackRock, also warned in the foreword to the asset manager's annual report that its strength could "lead to an erosion in confidence on the part of CEOs with the potential to slow both investment decisions and future growth in the US".

No matter when the Fed decides to move, however, most analysts and investors are confident that a rate increase is unlikely to send longer-term Treasury yields much higher.

Shorter-dated bonds may take a slight hit, but given the paucity of yields elsewhere in highly-rated government bond markets, few foresee the 10-year yield moving much higher from its roughly 2 per cent level - irrespective of timing and pace of Fed rate increases. "Some hikes are already baked in the cake, so that won't send the long end up much," argues Ajay Rajadhyaksha, a senior strategist at Barclays.

Instead, the "Great Flattening" of the US bond market - where the difference between short-dated and longer-dated bond yields narrows - is expected to continue. The spread between the 30-year and two-year Treasury yields has dived to just over 2 percentage points, down from over 3.5 percentage points at the start of 2014.

Nonetheless, the Federal Reserve's policy makers face a daunting task in lifting its benchmark rate off zero without upsetting bond markets, denting confidence and choking off an economic pick-up that only looks strong in comparison with the eurozone's spluttering recovery. Even a modest rise in the 10-year Treasury yield could have an outsized impact on other corners of the market that use US government debt as a pricing benchmark.

"The Fed has one of its most challenging rate hiking cycles ahead of it," Mr Kushma notes.

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