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U.S. markets polarized on Fed rate outlook

Thursday February 5, 10:59 am ET
By Amanda Cooper

NEW YORK, Feb 5 (Reuters) - U.S. financial markets appear to be at odds over the timing and size of the U.S. central bank's next rate rise, after the Fed created an earthquake last week by dropping two words from its policy statement.

Investors in interest rate futures, a gauge of the market's expectations for monetary policy, appear to have taken the Fed at its word that it can be "patient" in raising rates from their current 45-year low of 1.00 percent.

But the Federal Reserves's decision last week to drop its commitment to keep rates low for a "considerable period" riled the bond market and investors scrambled to unload Treasury holdings and prepare for rate hikes sooner rather than later.

Short-term Treasuries staged their largest one-day rise in a year to nearly 2.00 percent after the Federal Open Market Committee ( News - Websites ) (FOMC ( News - Websites ) ) made its post-meeting statement on Jan. 28, increasing the gap against the current interest rate to its widest since June 2003.

But interest rate futures are barely pricing in a full percentage point of rate increases for the whole of 2004.

This is mainly due to the Fed's reluctance to tighten policy until it sees enough job creation to prove that the economic recovery is self-sustaining and inflation pick up from worryingly low levels.

Data on manufacturing, services and business activity show the economy is firing on nearly all cylinders, but job creation still seems sluggish. That has curbed any excessive bearishness in fixed income markets like bonds and rate futures.

"The market is still thinking along the lines of gradualism and the futures are priced for the typical Fed response to address whatever inflation fears they might worry about," said Tony Crescenzi, chief bond strategist at Miller Tabak & Co.

"The market knows that (Fed chairman) Alan Greenspan ( News ) tends to move gradually when raising interest rates and...that's reasonable given what the Fed has been telling us in terms of their intentions on policy," he said.

Eurodollar rate futures (O#ED:), a contract on three-month money rates, are pricing in the first quarter-point of tightening by June this year, and show investors expect rates to be just below 2.00 percent by the end of the year.

When the Fed dropped its "considerable period" mantra last week, eurodollar futures were implying rates of nearly 2.25 percent by December.

"There's a bit of a battle in people's hearts and minds about the meaning of Fed's recent language-change at the FOMC: 'Did it mean something or didn't it mean something?'" Jon Blumenfeld, interest-rate strategist for BNP Paribas, said.

"I think it was a significant change in that they could not really justify raising rates without getting rid of that 'considerable period' comment first," he said.

Blumenfeld said BNP Paribas was expecting to see the Fed funds rate around 2.5 percent by the end of the year, with the first rate rise in May or June.

BNP Paribas' timetable coincides roughly with what is priced into Fed funds interest rate futures, a contract on the central bank's overnight target rate.

Fed fund futures (O#FF:) are less liquid further out the curve than eurodollar futures but more accurate in predicting near-term shifts in interest rates.

Any hint of a rise in inflation or more rapid job creation, as gauged by the Labor Department's non-farm payrolls report, could cause the market to bring forward its timing dramatically as investors sell off, analysts said.

"I think that particularly Fed fund futures are ... vulnerable -- forgetting what our call (on rates) is -- to some kind of good news on the economy that could make them sell off sharply and the same goes for the eurodollar futures," Blumenfeld said.

January non-farm payrolls are due on Friday and are forecast to rise by 150,000, compared with December's shockingly low increase of 1,000 that disappointed many hoping for the kind of job creation the Fed is seeking.


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