Are markets poised for Taper Tantrum 2.0?

Jul 17 2014, 11:44 IST
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SummaryUS bond markets also have shown little sign of prepping for a rate hike.

Investors may be ignoring subtle warnings from the Federal Reserve that a rate rise may come sooner than they think, setting the stage for another painful market contraction much like last year's "taper tantrum."

Catching investors off guard is the last thing U.S. central bankers want to do, which helps explain their repeated recent warnings over complacency in financial markets, and Fed Chair Janet Yellen's pointed comments this week about banks and others building up dangerous "interest rate risk."

Yet many Wall Street economists, skeptical that the economy will finally break out of its recessionary funk, do not believe the Fed will tighten its extraordinarily easy monetary policy as soon or as aggressively as its forecasts suggest, surveys consistently show.

U.S. bond markets also have shown little sign of prepping for a rate hike. Meanwhile most Fed policymakers have been surprised by the sharp drop in unemployment and pleased by signs that inflation is firming. They are wrapping up an asset-purchase program and starting to detail exactly how they plan to raise rates from near zero.

"I don't think people have really internalized how rapid the decline (in unemployment) has been," St. Louis Fed President James Bullard said in an interview.

If strong jobs growth continues, and if economic growth bounces back from a decline in the first quarter, "there will be a lot more talk about an earlier date of possible liftoff."

Bullard has warned that the Fed is now closer to its inflation and unemployment goals than at any time in about a decade. Hawkish relative to most colleagues at the Fed, he wants to see a rate rise in the first quarter of next year, about four months ahead of the market. And he is not alone: on Wednesday, Richard Fisher of the Dallas Fed said rate hikes are "likely" early next year. [ID: nL2N0PR1IX]

"There can be volatility in markets, and sometimes there is kind of a realization that an existing view is not panning out ... and there is a sudden adjustment in markets," Bullard told Reuters. "One of the good things about talking about the economy every day and reassessing the data every day is you get that process to be more gradual."

Based on futures trading at the CME, investors have been fixated for most of the year on July 2015 for a small rise in the key federal funds rate. The chance of a March rate rise, in their view,

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