Who needs the Fed? The rate hike cometh on its own

[July 31, 2015]  By Richard Leong and Jonathan Spicer

NEW YORK (Reuters) - As traders, market pundits and economists jaw over whether the Federal Reserve this year will lift its benchmark lending rate for the first time in almost a decade, several corners of the U.S. bond market aren't waiting around.

A wide range of short-term interest rates, which tend to be the most sensitive to Fed policy expectations, have been quietly grinding higher for weeks, or in some cases much longer. Several have even surpassed their levels from two years ago during the bond market's "taper tantrum," when prices tanked and yields shot up as the Fed pondered whether to halt its massive asset-purchase program.

Banks, money market mutual funds and other investors want to avoid being stuck with low-yielding debt when the U.S. central bank finally does begin raising interest rates, something it last did in June 2006. Generally positive commentary about the economy from the Fed at the conclusion of its latest policy meeting on Wednesday is seen by many as signaling that a rate rise could come as early as September.

"The confidence is starting to rise about a rate hike," said Gennadiy Goldberg, interest rate strategist at TD Securities in New York. "You want to be compensated for at least one hike."

For example, overnight bank borrowing rates have been inching up for the better part of a year and are around 36 percent more costly than in May 2014, when they hit a record low.

Yields on investment-grade corporate bonds are holding near recent two-year highs, and the premium paid for holding them relative to Treasuries is the steepest since September 2013.

And even as yields on bond market benchmarks like the 10-year Treasury note <US10YT=RR> and 30-year T-bond <US30YT=RR> have seen only intermittent upward pressure, those on shorter-dated Treasuries are decidedly higher.

The yield on two-year Treasury notes <US2YT=RR>, at 0.73 percent on Thursday, is just a tick from its highest level since April 2011 and is more than three times higher than it was in May 2013. Rates on T-bills, with durations less than a year, have hit their highest level so far this year.

Yields, or rates, move inversely to the price of bonds.

To be sure, the Fed could still blink in the face of international headwinds to U.S. growth such as Greece's unresolved debt woes and stock market turmoil in China that could undermine its economy, the world's second largest. And a fresh bout of weakness in oil markets could make it difficult for inflation to move in the direction desired by the Fed.

To that end, some measures of Fed rate expectations suggest almost no probability the central bank will move before December. Fed fund futures prices reflect a zero percent chance of a rate hike in September, a 37 percent chance in October and a 64 percent chance in December, according to CME Group's FedWatch.

To head off undue turbulence, the Fed has long emphasized that it expects to raise interest rates only gradually from near-zero, unlike the tightening cycle last decade in which policymakers hiked borrowing costs slightly at every meeting.

In recent weeks and months, policymakers have also stressed that the timing of the initial rate rise is less important than how the economy evolves thereafter. Cleveland Fed President Loretta Mester even gave a speech this month entitled “Timing isn’t Everything.”

WHITES OF FED'S EYES

Still, overnight borrowing costs between banks are a reliable proxy that traders expect short-term U.S. rates will be heading higher sooner than later.

The federal funds effective rate, which the Fed seeks to control, has averaged 0.14 percent for three days in a row, matching its highest level since May 2013. That is 1.5 basis points above the midpoint of the zero-to-25-basis-point target range the Fed adopted in December 2008. A basis point is a hundredth of a percentage point.

Another key rate, the three-month London interbank offered rate, or Libor, a benchmark for $350 trillion worth of financial products worldwide, topped 30 basis points on Wednesday for the first time since January 2013.

And a type of interest rate swap designed to anticipate the Fed policy rate around the time of its next meeting in September now reflects a rate around 2 basis points above the top of the Fed's current target range.

For some, though, the most telling signal in recent days is the rise in interest rates on Treasury bills.

The interest rate on three-month T-bills <US3MT=RR> that mature on Sept. 17, when the Fed releases its next policy meeting statement, rose to almost 7 basis points on Thursday, the highest level in nearly 14 months.

"T-bill rates are usually the last to move. They only move when they see the whites of the Fed's eyes," TD's Goldberg said.

(Editing by Dan Burns and Leslie Adler)

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