From the July 01, 2010 issue of Futures Magazine • Subscribe!

Economic recovery: Are we there yet?

Economic uncertainty has been the order of the day since the market crisis of 2008, resulting in interest rates near zero. At the beginning of 2010, the market expected the Federal Reserve to begin its exit strategy by raising interest rates in the second quarter, but those expectations were pushed back due to instability in the financial markets and, to a certain degree, by the sovereign debt crisis in Europe.

In the minutes of its April 27-28 meeting, the Federal Open Market Committee (FOMC) said economic conditions would equal “exceptionally low levels of the Federal Funds rate for an extended period,” and most members predicted economic slack “would continue to be quite elevated for some time, with inflation remaining below rates that would be consistent in the longer run with the Federal Reserve’s dual objectives.” And inflation concerns seem to be in check, as the minutes also noted that consumer price inflation was low in recent months and survey measures of long-term inflation expectations were fairly stable.

Analysts expect the Fed to begin raising rates at the beginning of 2011 at the earliest. And based on Fed Funds futures, most traders don’t expect a rate hike until early 2011 (see “Watching the Fed”).

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“The combination of the European crisis, [concerns] about China overheating, and evidence that the U.S. inflation story is not inflation but deflation, has given us an [unusual] rate structure,” says Cary Leahey, senior managing director at Decision Economics. “In the short run, as long as the EU and China are on the front pages of the financial publications, the worst-case scenario for U.S. interest rates is sideways. The Fed’s not going to hike interest rates until 2011. The structure on rates is flat to up.” Leahey predicts 3.75-4% on the 10-year yield by the end of 2010. “We’re probably now at the lows,” he says, adding that he expects interest rates to be 50-100 basis points higher than the current levels by the end of the year.

Kim Rupert, managing director for fixed income at Action Economics, also doesn’t expect a rise in interest rates until 2011 and says the market likely won’t try to push rates up on its own because the recovery is still very modest. “With inflation not appearing too threatening right now, especially if the labor market doesn’t improve much and the recovery remains very tepid, the vigilantes [won’t] have much of a case” to push rates up on their own, she says. For the end of the year, she predicts three-month Libor at 99.150, 30-year futures at 118-04, 10-year futures at 117-13, five-year futures at 115-25, and two-year futures at 108-15.

Carley Garner, trader and analyst at DeCarley Trading, says the market may attempt to push rates higher, “but [I doubt] they’ll be successful. We won’t get any dramatic changes in interest rates based on investor moves and manipulation.” She expects 10-year futures to be above 115 at the end of the year, likely most comfortable near 117, and says the 30-year bond could be trading in the 114 to 116 range by year’s end.

Mike Kimbarovsky, principal at Advocate Asset Management, expects the Fed to begin its exit strategy at the end of 2011 or in 2012, after first selling assets on the Federal balance sheet. “That will have the secondary impact of raising capital markets rates, so they don’t have to raise the official interest rates to get the capital market rates to rise,” he says. By the end of 2010, he expects the 10-year yield to be in the 3.5% range, the two-year to be at 1%, and the 30-year to be in the 4.5% range. As for the three-month Libor, he says, “I wouldn’t be surprised if it went to the mid-3s. I don’t expect major movements.”

Dave Floyd, head of FX research and trading at Aspen Trading Group, also doesn’t expect Libor to move much as long as long as Spain and Portugal don’t implode economically. “If there are no crises, Libor should be okay for the remainder of the year. I’m looking for rates to be sideways or in a trading range,” he says, adding that on the 10-year yield, “if we hold the 3% level, we’re going to be in a trading range for the rest of the year, between 3%-4%.” He doesn’t expect the market to take rates higher, saying it will want to see some indication that economic growth is on firmer footing first.

Euro funk

The economic crisis in Europe began with severe weakness in Greece and other PIIG nations (Portugal, Ireland, Italy), leading to a major battering of the euro and subsequent €750 billion ($1 trillion) joint European Union and International Monetary Fund bailout package for Greece in May 2010. Analysts say the situation in Europe could have an impact on recovery in the United States. However, weakness in Europe also could have a domino effect and lead to weakness in China, a major driver for worldwide economic growth.

“The repercussions around the world of weaker European growth [could] hurt Asian exports to Europe. So Europe’s downfall will mean weakness in export-driven countries, such as most of Asia. If Asia weakens, especially China, that’s going to bring down the growth rate around the world,” Rupert explains.

“The European government is in the driver’s seat when it comes to recovery,” Garner says. “If they don’t contain their debt problems there, it’ll basically freeze the credit markets.”

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