September 29, 2014 / 5:09 PM / in 3 years

New Fed study suggests traders' rate path view lags that of Fed

SAN FRANCISCO (Reuters) - The Federal Reserve will likely start raising interest rates in mid-2015, but so slowly that rates will end the year at just 0.55 percent, according to a San Francisco Fed study of betting in futures markets released on Monday.

The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013. REUTERS/Jonathan Ernst

By the end of 2016, rates will have risen to just 1.4 percent, based on options contracts on short-term interest-rate futures, according to San Francisco Fed economist Michael Bauer. The paper argues that options are better gauges of market expectations than futures contracts themselves when interest rates are near zero.

The bets suggest traders see the Fed raising rates at about half the pace that Fed officials themselves do. Fed officials see rates ending 2015 at 1.375 percent, and 2016 at 2.875 percent, based on the median of forecasts released by the U.S. central bank earlier this month.

It is the second study from the San Francisco Fed this month that suggests market expectations on rate hikes are behind the curve as seen by the Fed. Unlike the earlier study, Bauer’s does not explicitly compare market expectations to Fed officials’ forecasts, but focuses instead on a comparison of options and futures.

Futures contracts suggest a slightly more aggressive path of rate hikes than options, Bauer wrote, but such a reading of markets is “misleading” because it does not take into account the fact that near-zero interest rates prevent traders from the two-sided betting that is possible when rates are above zero.

“Option-based estimates of the most likely policy path indicate that market participants expect liftoff to occur around the middle of 2015, and further expect the subsequent policy tightening to be gradual,” Bauer wrote.

The Fed has held interest rates at zero to 0.25 percent since December 2008.

Reporting by Ann Saphir; Editing by Chris Reese

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