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5 Flags the Market Is Waving at the Fed

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So, it’s little wonder they’re discounting central bankers’ talk of higher borrowing costs in 2015 as oil plunges, roiling markets worldwide and lowering the growth outlook.

“The Fed believes it understands market turmoil,” Jim Vogel, a fixed-income strategist at FTN Financial, wrote yesterday in a research note. “Central banks have a lot more to learn when it comes to global financial conditions.”

Fed policy makers concluded a two-day meeting in Washington on Wednesday after discussing their plan to withdraw monetary stimulus and hashing out what the collapse in oil means for the outlook. Central bankers said they’d be “patient” on the timing of the first borrowing-cost increase since 2006 and lowered their forecast for interest rates at the end of next year.

Here are five ways traders have been telling the Fed that they should postpone their tightening strategy:

1. Inflation expectations have fallen close to where they were right before the Fed embarked on its second round of bond purchases, or quantitative easing, in 2010. QE2 was controversial because it fueled concern that inflation would spike (that never happened), but expectations that prices would accelerate faster were exactly what central bankers wanted. Traders are pricing in consumer price increases over the next five years of about 1 percent — well below the Fed’s 2 percent goal for price stability.

2. U.S. corporate borrowing costs are skyrocketing, especially for the riskiest debtors – see chart – assuaging concerns that the market had gotten frothy. For junk-rated energy companies — whose business models are being called into doubt with oil at less than $60 a barrel — yields have almost doubled to 10.4 percent on average from 5.7 percent in June, according to Bank of America Merrill Lynch index data. Capital spending at these companies is certainly not going to be what it has been.


3. Then there’s the bloodbath in commodity prices. Prices on everything from oil to corn and copper have plunged 14 percent this year to the lowest since April 2009, according to a Bloomberg index. If the carnage continues, that’ll further drag down those inflation expectations and the need for the Fed to tighten monetary policy.

4. Market stress is on the rise. The price of insurance against declines across asset classes has risen to a 15-month high, according to an index of financial stress compiled by Bank of America Corp. that tracks volatility in equities, U.S. Treasuries, currencies and commodities. A worsening selloff may not be the best time to raise interest rates.


5. Traders disagree with the Fed’s forecast that benchmark interest rates will approach 4 percent in the longer run. The bond market is pricing in shorter-term rates of about 2.66 percent, based on a one-year interest-rate swap traded five years forward — see chart. The market is telling U.S. central bankers they should reconsider their plans.