Rate traders may be too hawkish on Fed

The Fed will begin publishing its forecasts for borrowing costs and its first rate hike at its next meeting on Jan. 24-25, according to minutes from its Dec. 13 meeting that were released on Tuesday, a significant milestone in Fed Chairman Ben Bernanke's push for greater policymaking transparency.

Many analysts say the Fed will now tell markets not to expect a rate increase until 2014 at the earliest, a move that should reprice the interest rate futures markets and send short and intermediate-dated debt yields tumbling from already historic lows.

"It seems a pretty safe bet that when they give us the new communications strategy they are going to communicate to the market that rates will be held lower for longer," said Suvrat Prakash, an interest rate strategist at BNP Paribas in New York.

"That would help anchor yields at these low levels or possibly even lead them lower," he said. Prakash said five-year note yields, for example, could drop to about 60 basis points from 89 basis points currently.

The Fed said in August it will hold rates at 0.25 percent until at least mid-2013.

US growth has further disappointed many Fed members since that statement, in spite of the launch of the Fed's third round of quantitative easing, in which it sells short-dated notes and buys longer-dated bonds in a bid to lower longer term borrowing costs.

"The downside risks and the tone is nothing close to optimistic in the minutes," said Tom Porcelli, chief US economist at RBC Capital Markets in New York. "You're looking at probably 25 basis points for at least a year longer than most people are thinking right now."

Fed funds futures contracts are likely to re-price to push back expectations. Currently the contracts imply the rate will increase to as much as 1 percent by the end of 2014 from its current 25 basis points.

Market reaction to Tuesday's Fed minutes has so far been relatively muted, which may in part reflect uncertainty over how the Fed will present its forecasts, said BNP's Prakash.

Unknown is whether the central bank will list each member's forecast separately or give a range or median. Also unclear is whether the Fed will remove the 2013 target from its language.

"There are more questions than provided answers," said RBC's Porcelli.

FUNDING LEVELS STABLE

Some closely watched funding indicators eased slightly as euro-zone banks locked in long-term dollar funding from the European Central Bank, underscoring the heavy dependence on official lending lines but shoring up refinancing needs for the near-term.

Thirty-four banks borrowed a total of $25.5 billion at the ECB's latest offering of three-month funding, and 12 banks bid for 6.2 billion of seven-day loans. This replaced $33 billion of maturing short-term loans and $1.4 billion borrowed in October.

The three-month dollar London interbank offered rate held steady at 0.58250 percent, its highest level since July 2009.

The premium to swap euros into three-month dollars in the currency swap market held relatively steady at elevated levels of 1.09 percent but remained well under recent highs of around 1.60 percent.

Copyright Reuters, 2011