Markets are upping bets that the U.S. Federal Reserve will hike interest rates sooner than expected as the world’s biggest economy recovers, with U.S. rates seen rising faster than those in the crisis-hit euro zone.
A run of strong economic data has raised speculation that the Fed may need to look again at its commitment to keep interest rates low until the end of 2014.
“Obviously after the last (Federal Reserve) meeting we’ve had more and more market participants questioning whether the Fed will keep rates so low for so far out. That’s a reasonable question,” said Elwin de Groot, market economist at Rabobank.
Despite some spillover from the United States, euro zone interest rate futures reflect a more cautious long-term outlook, with fears that low growth would hurt the bloc’s chances of escaping its long-running debt crisis.
“Yes, there is a correlation with the U.S., but (Europe) has its inherent fundamental problems which are very much ongoing,” said Simon Peck, strategist at Royal Bank of Scotland.
As a result, the U.S. Eurodollar futures curve – which shows how quickly markets expect rates to rise – has been steepening to show a more aggressive Fed rate-hiking cycle. Euro zone-equivalent Euribor futures have steepened less.
The interest rates implied by Eurodollar and Euribor futures reach parity around 1.5 percent in the first quarter of 2015, six month earlier than markets were anticipating just two weeks ago. U.S. rates then accelerate above the euro zone.
The U.S. base rate is currently 0.25 percent, compared with 1 percent in the euro zone, meaning that for rates to converge the Fed has to hike more aggressively than the European Central Bank.
RBS strategists look for increasing divergence between euro zone and U.S. rate futures contracts dated between March 2014 and March 2015. In the event of continued strong U.S. data for April and May, Eurodollar contracts expiring between 2014 and 2016 were most likely to sell off, implying expectations of higher rates, RBS said.
LONG ROAD AHEAD
One driver behind this change in outlook are the different approaches of the Federal Reserve and the ECB to managing policy expectations.
While the ECB never pre-commits on rate changes and gives few hints on long-term rates, the Federal Reserve has used assurances of “low rates for longer” as an important element of its monetary policy.
As a result, the Fed’s commitment had heavily suppressed rate rise expectations for the next two years.
But continued strong data has emboldened market participants to price in a change of heart by the Fed, and with rate expectations at rock-bottom levels the repricing could have much further to run, said Simon Smith, chief economist at FxPro.
“It probably is a sustainable trend… whereas there was once a ‘Don’t fight the Fed’ view, now we’ve seen a decent-ish run of data so far this year markets are feeling a bit more brave,” he said.
Nevertheless, while the long-term view may be for higher U.S. rates, there remain many hurdles that could derail the current trend well before a rate hike becomes a reality.
“If you look at the U.S. economic situation, obviously it’s improving now but from a longer-term perspective they still have to redress their deficit problems and that may imply a negative outlook on the economy,” Rabobank’s de Groot said.
“You could argue that once they start trimming back the deficit more durably, actually the Fed will have to be there to support that process and keep rates low.”
By William James – reuters.com