January 15, 2016 / 4:17 PM / in 2 years

Rate rise calls evaporate as markets plunge, murmurs of Fed reversal

* 10-year Treasury yield below 2 pct

* Global economy, markets fragile

* Recent history shows policy can be reversed

By Jamie McGeever

LONDON, Jan 15 (Reuters) - The worst ever start to a year for financial markets has left traders and economists rethinking the global monetary policy outlook, with some predicting the Federal Reserve will quickly reverse last month’s historic rate rise.

The Fed lifted U.S. interest rates for the first time in nearly a decade on Dec. 16, signalling its faith that the economy had finally put the 2007-08 financial crisis behind it.

Ferocious volatility fuelled by worries about China’s currency and stock markets has since wiped trillions of dollars off world stocks, however, while a slowing China has exacerbated worries about the robustness of U.S. economic growth.

Interest rate futures traders are already paring back their expectations of when the Fed might tighten again while several big banks this week dovishly revised their 2016 outlooks for the Bank of England, European Central Bank and Bank of Canada.

“You shouldn’t underestimate that a change in where the market sees rates going could happen pretty quickly. Another month of what we’ve seen this year, and we could be there,” said Steve Barrow, head of G10 strategy at Standard Bank in London.

The Fed made clear when announcing “liftoff” that it broadly anticipated four further 25 basis point increases this year, a view echoed by Fed officials in recent speeches.

The latest Reuters poll of 120 economists points to the federal funds rate, currently 0.25-0.50 percent, reaching 1.00- 1.25 percent by the end of the year and rising more in 2017.

But U.S. interest rate futures markets show barely two rate hikes priced in for this year, while the 10-year Treasury yield has slumped below 2 percent. It was 2.30 percent when the Fed raised rates last month.

The timing of any volte face from the Fed isn’t yet reflected in market pricing, and examples from Sweden, Australia and the euro zone -- where central banks were forced to reverse rate hike cycles -- show it may not be until the last minute.

All those central banks raised interest rates after the 2008 crisis, but now have them at historic lows -- below zero in the case of Sweden.

“The markets don’t believe the Fed. I said at the time of the December raise it was a mistake and gave a 50/50 chance that the next move would be a cut,” said David Blanchflower, professor of economics at Dartmouth College in New Hampshire and a former Bank of England policymaker.

“September may be the meeting when we see a cut, but maybe sooner if markets continue to collapse.”

Some $5.7 trillion has been wiped off the value of world stocks in the first nine days of the year, according to Bank of America Merrill Lynch.

UNDER PRESSURE

Joe Lavorgna, chief U.S. economist at Deutsche Bank in New York, says there have been 12 tightening cycles over the past 60 years, averaging 24 months during which the fed funds rate has risen 531 basis points.

But economies worldwide are still scarred by the financial crisis, which prompted the Fed to expand its balance sheet by $4 trillion and hold rates at zero for almost seven years.

JP Morgan was among several banks this week to push back the expected of timing of a first British rate rise to the end of 2016, predict more easing from the European Central Bank and call for a rate cut in Canada next week.

For those wondering when U.S. rates markets might turn, a look at behaviour around the recent policy reversals in Sweden, the euro zone and Australia is instructive.

In July 2011, after a year of hikes by Sweden’s Riksbank that took rates from 0.25 to 2 percent, three-month overnight index swap rates, a measure of rate expectations, rose as high as 2.25 percent, implying a further tightening. The central bank in fact began cutting in late 2011, after which rate expectations declined for four years.

The Reserve Bank of Australia began raising in late 2009 from 3.00 percent, finishing at 4.75 percent a year later.

Aussie rate futures gave the first glimpse of a shift towards pricing in a cut in August 2011, rising 25 basis points to 95.50. But they quickly fell back and only rose in earnest at the end of October when the RBA started cutting.

A rise in the price of interest rate futures contracts implies an expected fall in actual interest rates.

The ECB, meanwhile, hiked from 1 percent in early 2011 to 1.5 percent later that year, only to start cutting a few months later as the euro zone’s debt crisis escalated.

Euribor rate futures rose 0.4 percent in price between July and September, suggesting a shift in traders’ bets, but quickly retreated and only moved decisively in mid-October once the ECB started cutting.

Analysts say it is extremely difficult for rates futures curves to show anything more nuanced than a broad direction.

“You can have one bump in the curve, the turning point of the cycle, but you can’t have two. To get even one bump in the dollar curve you’d need to get more altitude at the short end,” said Societe Generale rates strategist Ciaran O‘Hagan.

Markets tracking the Fed are more liquid than those tracking the Riksbank and RBA. And the Fed, aware of its responsibility as the world’s largest and most important central bank, has been in no-surprises mode for some time.

Futures contracts show bets that the next move in U.S. rates will be up are currently the heaviest since the end of 2014 but sustained volatility across world markets could yet force the Fed’s hand.

In September, it backed away from a widely expected rate rise -- sparking steep falls on Wall Street and other markets -- citing China’s mini currency devaluation a month before. (Editing by Catherine Evans)

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