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Bond Market’s Message to Fed: Your 4 Percent Rate Forecast Is Too High

“The bond market, unparalleled in predicting shifts in the U.S. economy over the decades, has a message: interest rates aren’t going to rise as high as even the Federal Reserve’s own forecast.

From bond yields to futures and swaps, traders see little chance the economy will strengthen enough over the course of its expansion to compel the Fed to lift its overnight rate beyond about 3.3 percent. That’s less than the historical average of 4.25 percent that New York Fed President William Dudley said would be consistent with the central bank’s current target for inflation and compares with its long-term estimate of 4 percent.

The divergence reflects deepening concern among bond investors that tepid wage growth and a lack of inflation will persist for years to come, and hold back growth as the Fed moves to end its unprecedented monetary stimulus. Lower peak rates will also reduce the likelihood of any selloff in longer-term Treasurys, which have rewarded holders this year with the biggest returns in two decades.

“The market’s pricing in an extraordinarily slow Fed,” Margaret Kerins, the Chicago-based head of fixed-income strategy at Bank of Montreal, one of 22 primary dealers that trade with the central bank, said by telephone on May 20. “Potential growth is a huge determinant of that long-term rate and most people are buying into the idea of lower potential growth.”

BMO forecasts the central bank’s benchmark Federal funds target rate will peak at 3.75 percent. The Montreal-based bank’s estimate for the terminal rate, as it’s known in the bond market, was 4 percent at the start of 2014.

Mixed Signals

While economists say the Fed will keep its benchmark rate between zero and 0.25 percent until 2015, traders are already weighing in on how high it will ultimately go.

In the Fed’s “dot plot” of interest-rate projections released on March 19, the median year-end estimate was 1 percent for 2015 and 2.25 percent for 2016.

The market’s view is about 0.63 percent and 1.64 percent, based on the implied yield premium of Eurodollars, the world’s most actively traded short-term interest rate futures, over swaps priced to the Fed funds effective rate in those years.

The Fed’s “long-run” forecast is also 0.7 percentage points higher than traders foresee by 2019. The rate on a one-year interest-rate swap traded five years forward, another proxy for short-term rates, fell to 3.4 percent this month, data compiled by Bloomberg show.

“The market clearly doesn’t believe in the Fed’s forecasts,” Thomas Costerg, an economist at Standard Chartered Plc, said in a May 21 telephone interview from New York.

Fed Skeptics…”

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