Fed stuck at zero into 2015 seen in swaps, QE odds reach 99%

Just six months ago, money market traders expected the Federal Reserve to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens.

Bond market measures from overnight index swaps, which indicate no increase in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008.

Investor expectations for sluggish growth and low inflation remain intact even though the collapse of Lehman Brothers Holdings Inc., which triggered the worst financial crisis since the Great Depression, happened four years ago. While the economy expanded in the second quarter, the unemployment rate remained above 8 percent for the 43rd-straight month in August.

“The problems have been bigger than anticipated and it will take a while to work our way through these issues,” Larry Dyer, a U.S. interest-rate strategist in New York with HSBC Holdings Plc’s securities unit, said in an interview on Sept. 6. “The bond market is pricing in pretty close to a very prolonged period of low growth,” said Dyer, whose company is one of the 21 primary dealers that trade with the central bank.

Jobs Report

Payrolls rose by 96,000 in August, the Labor Department said Sept. 7, below the 130,000 median estimate of 92 economists in a Bloomberg News survey, and the unemployment rate was 8.1 percent. Growth slowed to an annualized rate of 1.7 percent in the second quarter from 2 percent in the first, according to the Commerce Department on Aug. 30. That compares with the 3.2 percent average increase in gross domestic product since 1950.

Bonds rallied following the report on speculation that policy makers will announce plans as soon as this week to pump more money into the economy to bolster growth by keeping yields low. For the week, 10-year Treasury yields rose 12 basis points, or 0.12 percentage point, according to Bloomberg Bond Trader prices. The yield was little changed today at 1.66 percent as of 10:19 a.m. in London.

Fed Chairman Ben S. Bernanke said on Aug. 31 in Jackson Hole, Wyoming, that he wouldn’t rule out steps to lower a jobless rate he described as a “grave concern.”

He said additional bond purchases on top of the $2.3 trillion in so-called quantitative easing since 2008 are an option. He said past adjustments to the guidance policy makers have given on rates have been an effective way to signal policy.

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