Fed Faces Pressure to Raise Rates, Options Show
(Update2)
By Daniel Kruger
June 4 (Bloomberg) -- In the options market where the
savviest investors take apart conventional wisdom, the
Federal Reserve is facing growing pressure to consider
raising interest rates as soon as December.
Options on Federal Fund futures at the Chicago Board
of Trade indicate a 41 percent chance the central bank
will lift its target rate for overnight loans between
banks to 5.5 percent from the current 5.25 percent,
according to data compiled by Bloomberg. A month ago,
they showed no expectations for an increase.
While the economy expanded at the slowest pace in more
than four years in the first quarter, inflation
remains at the top of the Fed's comfort zone, business
activity has rebounded, the jobless rate is near the
lowest in six years and stock indexes are setting
record highs. Just three months ago, options traders
speculated the weakest housing market in 16 years
would force the central bank to cut interest rates to
4.5 percent by January.
``The economy is in better shape than people give it
credit for,'' said Jamie Jackson, who oversees
government debt trading at RiverSource Investments in
Minneapolis, which manages $100 billion of bonds.
``People exaggerated the pass-through effects of the
housing weakness. If the Fed were to do something by
year- end it would be a tightening.''
The chance of at least one cut in the overnight
lending rate between banks has fallen to 29 percent
from 83 percent since the start of May, options prices
show.
`Not Satisfied'
Federal Reserve policy makers ``have started to tell
us in pretty consistent language they're not satisfied
at being at the upper band'' of their inflation
target, said Stan Jonas, who trades interest-rate
options in New York at Axiom Management Partners LLC.
``One-third of the people think the next move is going
to be a tightening.''
Options more accurately reflect changes in monetary
policy than futures contracts, the most widely used
barometer, because they include the widest array of
wagers, according studies by the Federal Reserve Bank
of Cleveland in 2005 and the Federal Reserve Bank of
St. Louis in 2006.
The Cleveland Fed paper has influenced the study of
monetary policy expectations and follows a ``perfectly
sound procedure,'' said James Hamilton, an economics
professor at the University of California, San Diego.
The CBOT first listed the options in 2003 and began
offering contracts in July that allow bets on the
Fed's target rate. The so-called binary options pay
$1,000 if an investor bets correctly on the Fed's
interest-rate decision at regularly scheduled
meetings. Investors get nothing if they bet wrong.
Preferred Measure
Treasury yields climbed last week to the highest since
August. The yield on the benchmark Treasury note due
in May 2017 rose 9 basis points, or 0.09 percentage
point, to 4.95 percent. The yield fell 2 basis points
today to 4.93 percent.
Treasuries returned 1.1 percent so far this year,
compared with a 1.5 percent loss last year, according
to indexes compiled by Merrill Lynch & Co.
Personal spending on items excluding food and energy,
the Fed's preferred inflation measure, rose 2 percent
in April, at the top of the central bank's preferred 1
percent to 2 percent range. It had been above 2
percent the previous 12 months.
Central bankers reiterated their forecast for faster
growth and said ``downside risks'' to the economy have
``diminished slightly,'' according to minutes of the
May 9 Federal Open Market Committee meeting released
last week.
``Economic growth will pick up as we move through the
year,'' Federal Reserve Governor Randall Kroszner said
at a June 1 conference in Athens. ``The risks to the
inflation outlook are primarily to the upside.''
Merrill, Goldman, UBS
UBS AG and Merrill Lynch, among the biggest bond bulls
this year, changed their forecasts for Fed cuts. UBS,
based in Zurich, on June 1 pushed back expectations
for when the Fed will begin cutting rates to October
from August. Merrill, based in New York, said today it
now expects the central bank to remain on hold this
year after predicting as many four rate reductions.
New home sales rose 16 percent in April to an
annualized rate of 981,000, according a Commerce
Department report released May 24. Analysts attributed
the increase to developers reducing prices of unsold
houses. The average selling price dropped 10 percent,
the report said.
Gains in stocks that pushed the Standard & Poor's 500
index to a record 1535.56 on May 30 discouraged the
Fed from cutting rates, said David Rosenberg, chief
economist for Merrill in New York. Rosenberg predicted
at the beginning of January that rates would fall to
4.25 percent this year.
`Bat an Eyelash'
``We came off of virtual stagnation in the first
quarter and the Fed didn't bat an eyelash,'' Rosenberg
said.
Economists at Barclays Capital Inc., JPMorgan Chase
Inc. and Bear Stearns Cos. have been predicting higher
rates since the Fed left its target unchanged last
August. They forecast at least one increase this year
and another by the first quarter of 2008. Barclays is
based in London, while JPMorgan and Bear Stearns are
in New York.
``We'll see a pick-up in the growth rate of the
economy that will make the Fed a little less confident
with the rate of inflation,'' said Conrad DeQuadros,
an economist at Bear Stearns.
The U.S. economy grew at a 0.6 percent annual rate
last quarter, the Commerce Department said May 31. The
pace will increase to 2.2 percent this quarter,
according to the mean forecast of 65 analysts surveyed
May 9 by Bloomberg News. ``If housing can just behave
itself and get back some stability there is a risk
they could go to 5.5 percent,'' said George Fischer,
who manages $17 billion in fixed-income assets at
Boston-based Fidelity Investments, the world's largest
mutual fund company.
Building the Case
The economy added 157,000 jobs in May, while the
unemployment rate remained at 4.5 percent, the Labor
Department reported on June 1. The jobless rate
dropped to 4.4 percent in March, the lowest since
October and matching a five-year low.
Business activity rose last month, according to the
National Association of Purchasing
Management-Chicago's business barometer. The measure
increased to 61.7 in May, higher than economists
forecast, from 52.9 the prior month. Readings greater
than 50 signal expansion.
``The case is building more and more'' for Fed rate
increases, said Richard Schlanger, who manages $4
billion in fixed income at Pioneer Asset Management in
Boston. ``We are definitely seeing more and more
people moving away from the Goldman and Merrill
argument that the Fed is going to cut multiple
times.''
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