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June 16th 2009

Are US Short-term Rates Headed Higher?

This is a question that many investors found themselves asking last week, following the release of labor market data that showed employers are now shedding jobs at a slower pace than before. Short-term yields immediately jumped, as investors suddenly considered the possibility that the US economy would return to ‘normalcy’ sooner than expected. Two year Treasuries jumped to 1.3%, while “Eurodollar futures on Monday priced in a rise in U.S. interest rates of almost 1 percentage point within a year.”

There are two components that mandate the Fed’s approach to monetary policy in the US: inflation and economic growth. While both indicators are currently at dismal levels, economists are forecasting upticks in 2010. Commodities prices have already started to rebound. Combined with the Fed’s quantitative easing program and consequent explosion in liquidity, this could easily lead to inflation if not “mopped up” as soon as the economy begins to recover.

Still, concern over interest rate hikes represents a dramatic about-face from the last few months. During this time, investors grew comfortable with the seemingly contradictory notions that the US economy was already recovering and that the US Dollar represented a viable funding currency. In light of the most recent economic revelations, the former proposition seems even more tenable, which means that the inevitable rate hikes would make the latter less tenable. If indeed interest rate differentials shift, it would cause a huge change in current trading dynamics. “In a certain way the dollar has become a risky currency…You need your funding currency for carry trades to be stable, with very low-interest rates for a long time and it has also to be weak. Think about what’s going on in the U.S. and the conclusion is that the dollar may not qualify.”
euro-dollar-chart
Long-term rates have already begun to rise, due both to an oversupply in long-dated bonds and a decline in demand, as investors turn away from low-yielding assets. But currency traders (especially those that rely on carry trades) tend to favor short-term rates, which means that the Federal Funds Rate (and accompanying interest rates) supersede. While even the most hawkish Fed watchers don’t anticipate a rate hike for many months to come, the shift in forex markets indicates that investors are already calculating their exposure to such a hike.

Skeptics, meanwhile, insist that such hawkishness is way overblown and that “investors who bought the dollar recently betting on higher borrowing costs were at a ‘risk. Interest rates are not going to go up in this country anytime soon.’ ” Another analysts chimes in that, “It seems highly unlikely that the Fed will raise rates this year which…suggests that the dollar could come under renewed pressure in the event of a dovish shift in US interest rate markets.” I guess it just depends on what time horizon you look at.

Federal Funds Rate 1990-2009

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Posted by Adam Kritzer | in News, US Dollar | 1 Comment »

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One Review of “Are US Short-term Rates Headed Higher?”

  1. Forex Links for the Weekend | Forex Crunch Says:

    […] Adam Kritzer talks about the interest rate in the US, and asks if it will go higher. My answer Yes – an interest hike will come sooner than later. […]

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