There's uncommon dissent in the ranks of the Federal Reserve's primary dealers over the central bank's interest-rate decision this week.
Two of the Fed's 23 preferred bond-trading partners — Barclays Plc and BNP Paribas SA — are betting against their peers and the bond market by forecasting officials will raise rates Wednesday. It's the first time more than one dealer has gone against the consensus during the week of a policy meeting since last September, data compiled by Bloomberg show. Economists at both banks say traders have too steeply discounted officials' intent to hike after the Fed has remained on hold for longer than expected.
“There is no perfect time — there will always be some uncertainties in the data,” said Laura Rosner, senior U.S. economist in New York at BNP. “Despite a multitude of shocks through the last nine months, which have delayed the Fed, hiring has continued to be robust. There is a window of opportunity for the Fed to continue normalizing, and we think it'll take it.”
The bond market and Fed are locked in a battle of wills over the direction of interest rates more than seven years after the end of the recession. The central bank's credibility is at stake after policy makers began the year projecting four rate increases, after liftoff from near zero in December, yet remained on hold time and again because of economic circumstances in the U.S. and abroad. Even last month, Fed Chair Janet Yellen and Vice Chairman Stanley Fischer hinted that the bank could still raise rates twice this year.
The bond market isn't buying it. Futures traders are pricing in just a 20 per cent likelihood the Fed will lift its policy rate by 0.25 per centage point at its Sept. 20-21 meeting, based on the assumption that the effective fed funds rate will trade at the middle of the new Federal Open Market Committee target range after the next increase. That's down from more than 40 per cent in late August.
The yield on the Treasury two-year note, the coupon security most sensitive to Fed policy expectations, was 0.78 per cent as of 7:16 a.m. in London. That's barely above the 0.75 per cent federal funds rate upper bound implied by the hike that Barclays and BNP forecast this week. The two-year yield began the year at 1.05 per cent. The benchmark 10-year note yielded 1.7 per cent Tuesday.
Traders lowered the odds of a hike after employers added fewer jobs than forecast in August and service industry expansion slowed. For Barclays and BNP, those single data points belie broader labor-market strength, as shown by the largest three-month increase in nonfarm payrolls since January.
BNP wrote off any chance of a 2016 hike in February, when signs of slowing economic growth triggered volatility across global financial markets. Once the dust settled on Brexit in July, as stocks rallied and payrolls data rebounded, the bank saw September as the Fed's best chance to resume tightening monetary policy, Rosner said.
Barclays had forecast a rate hike at the Fed's June meeting until a dismal May jobs report at the beginning of that month. This is the first time the bank has called for a Fed increase through the week of an FOMC meeting since December, said Rob Martin, senior U.S. economist at Barclays.
“We're not the crazy house — this is the first time we've been so far out of consensus on the view,” Martin said. “We've kept our conviction on September because we think that's what the FOMC has communicated to us — that's what we think the chair and the vice chairman were talking about at Jackson Hole.”
Both Barclays and BNP say the decision to hike will be a close call, and their forecasts may not pan out. In general, the other primary dealers predict Fed officials won't move in September. Instead, they'll reiterate their intent to raise rates once in 2016, providing a clear signal for December. The trajectory of future rate hikes will likely fall.
Some dealers have said a September rate hike would spark market chaos. Tom Porcelli at RBC Capital Markets said an increase this month would be “the mother of all surprises.” Steven Ricchiuto at Mizuho Securities USA Inc. said a hike “would be comparable to the disruption in the markets caused by last year's ill-advised tightening.”
Those dire warnings aren't enough to dissuade Rosner at BNP, and she doesn't think the six Fed voters who appear open to a rate hike will be deterred, either.
“Markets are betting against it because they think the Fed has chickened out for the last nine months, so why wouldn't they do it again” she said. “But we can attribute the Fed's decision to pause to very specific shocks that just were coming from all directions. Now, here we are, the dust has settled, risks have diminished, and you have data that's decent. So if the Fed is on a regimen of gradual hikes, why shouldn't it continue”