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Analysis: Markets finally absorb Fed's two-track message

A general view of the U.S. Federal Reserve building as the morning sky breaks over Washington, July 31, 2013. REUTERS/Jonathan Ernst
A general view of the U.S. Federal Reserve building as the morning sky breaks over Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Ann Saphir

SAN FRANCISCO (Reuters) - After months of misfires, the U.S. Federal Reserve's message is finally getting through to Wall Street: to taper is not to tighten.

Even as the U.S. central bank moves closer to winding down its massive bond-buying program, most likely in the first quarter of 2014, short-term rate futures have rallied, pushing expectations for the first Fed rate hike deeper into 2015.

Traders now do not see the Fed raising short-term borrowing costs until at least July 2015, if not later, based on trading in CME Group's Fed funds futures.

That's a huge shift from late May, when Fed Chairman Ben Bernanke suggested that the Fed could start to reduce its $85-billion-a-month bond-buying program in "the next few meetings."

His remarks sent fixed income markets into a tailspin, with yields and rates on bonds of all stripes shooting higher, regardless of their maturity.

Expectations for a first rate hike fast-forwarded to as early as October 2014, well before most Fed officials themselves forecast. Even two months ago, around the time the Fed surprised markets by declining to begin the wind-down process, traders still saw the Fed as likely to begin raising rates from their current near-zero level by January 2015.

The shift is welcome news for U.S. policymakers, whose big worry has been that markets would react to a reduction of bond-buying by pushing up borrowing costs faster than the economy could safely absorb, undercutting the still-fragile recovery.

Indeed, that concern contributed to the Fed's September decision not to start reducing bond purchases yet.

"After the experiences of earlier this year ... I think the Fed knew they had to put a concerted effort into driving that wedge between tapering and policy tightening," said Millan Mulraine, a senior economist at TD Securities in New York. "I think they have been successful."

Minutes from the October 29-30 Fed policy-setting meeting, released on Wednesday, suggest the Fed is again open to reducing its bond purchases at one of its "next few meetings," as long as the economy continues to improve.

But this time, the market response showed more nuance. Benchmark 10-year Treasury prices fell, sending yields, which move in the other direction, to two-month highs above 2.8 percent. They did not drag short-term rates up with them, as happened in May.

In fact, Fed fund futures prices rose. That pegged the probability of a July 2015 rate hike at about 50 percent, down from about 52 percent before the minutes were released.

Some analysts contend that as long as short-term rates remain under control, longer-term rates should not overshoot.

The gap between yields on 10-year and two-year Treasuries, for instance, recently widened to about 2.52 percentage points, and now is less than 0.40 of a percentage point from its widest margin ever. As that spread approaches its historic limit, around 2.90 percentage points, bond traders are likely to begin buying longer-dated bonds bring the spread closer to historical norms, effectively putting a cap on the rise in longer rates.

"The good news is, if you control the front end, the back end has probably got some limit to how far it can go," said Alan Ruskin, global head of FX strategy at Deutsche Bank in New York.

Still, the resumption of even a slow upward grind in longer-term rates could itself be problematic for a Fed trying to ease off the monetary gas pedal without stomping on the brakes.

Such rates help determine borrowing costs for everything residential mortgages to business loans, and the Fed does not want to choke off the flow of credit to the economy.

When the labor market outlook improves enough for the Fed to finally reduce bond-buying, "I'd want that action to not adversely increase long term interest rates," Chicago Fed President Charles Evans told reporters earlier this week.

The Fed's current promise is to keep the rate it sets directly low until unemployment drops to at least 6.5 percent.

Evans said one way to avoid a sharp rise in 10-year yields in reaction in reaction to a tapering announcement would be to lower that threshold, an idea also floated by Fed economists.

October's minutes show that only a "couple" of Fed policymakers -- presumably Evans and his counterpart at the Minneapolis Fed, Narayana Kocherlakota -- support that route.

A more likely path is a promise the Fed will keep rates low for longer than might otherwise be expected, such as Bernanke's comment this week that rates could stay near zero until "well after" the jobless threshold is crossed.

"(Such guidance would) help take some of the sting away from the long-end of the interest-rate curve," said Scott Anderson, chief economist at Bank of the West in San Francisco. "They are very concerned that as they scale back on balance-sheet actions ... the long end will gallop higher."

Anderson said much of the recent rise in longer-term rates reflects reasonable expectations for a stronger economy in the future. Fewer Americans are filing new claims for jobless benefits, a report on Thursday showed, and one gauge of factory activity hit an eight-month high in early November.

TD Securities' Mulraine said the market needs assurances that the Fed will keep a large balance sheet that, by its very heft, presses down on long-term borrowing costs. Three rounds of bond-buying have swelled the Fed's asset portfolio to $3.86 trillion.

In June, Bernanke suggested the Fed will likely hold onto its mortgage-backed bonds even after it starts to raise rates. Further guidance on the Fed's balance sheet management plans may be a next step, Mulraine said.

"The Fed has done well in anchoring the front end," Mulraine said. "It can check one box, but it still has another."

(Reporting by Ann Saphir; Editing by Krista Hughes)

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