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Risk of faster US interest rate cycle looms

A new urgency is gripping financial markets. Talk of a Federal Reserve rate increase next week is no longer the main conversation, with interest rate futures now pricing it as a near certainty. How quickly the Fed moves after March is now the hot topic.

US jobs growth has been the catalyst. A survey by ADP revealed on Wednesday that 298,000 private sector jobs were created in February, dwarfing the 187,000 that economists expected.

That breathed new life into the spluttering dollar, which made significant gains on the yen, and pushed the index measuring the greenback against its peers close to a two-month high. The 10-year Treasury yield at 2.58 per cent stands at its highest level since mid-December.

If the official government payrolls report on Friday delivers something similar to the ADP — estimates are currently 190,000 new jobs for February — it will only harden attention on how many quarter-point increases the Fed can deliver in 2017, with knock-on effects for the dollar, Treasuries and equities.

Such talk was already in the market before the ADP report. On Tuesday, Jeffrey “Bond King” Gundlach, DoubleLine Capital chief executive, told investors they should now expect an old-school pattern of “sequential” rate rises from the Fed, a pattern he says will continue until “something breaks”.

David Tepper, the billionaire investor at Appaloosa Management, echoed this sentiment on Wednesday, telling CNBC: “I personally think the Fed will raise more quickly.” Throw in some delivery of President [Donald] Trump’s much-promised stimulus package, and a faster rate hike pace becomes a sure thing, he added.

It is worth noting that the correlation between the ADP report and official payrolls data is not particularly strong, says Anthony Karydakis, chief economic strategist at Miller Tabak. Others question whether monthly fluctuations in the labour market mean much when the US has more or less reached full employment.

However, any sense from Friday’s report that private sector job creation is accelerating “would have the potential for a significant adverse effect on both Treasuries and equities”, says Mr Karydakis.

The bond market has been showing signs of unease, with the 10-year yield rising at a faster pace than that of the policy sensitive two-year note over the past week. Usually, the two-year sector bears the brunt of selling pressure when the Fed is seen lifting rates.

In a reversal of the typical pattern, the yield curve, or relationship between the two- and 10-year notes has become steeper. A steepening of the yield curve can signal investors’ concern that the Fed needs to tighten policy at a faster pace to keep on top of inflationary pressures.

The very low level of the term risk premium is also playing a role, some argue. Based on the New York Fed’s measure, the 10-year risk premium has fallen back below zero after climbing to 0.21 per cent in early January. In late 2013, the 10-year term premium was at 1.80 per cent.

William O’Donnell, a fixed-income strategist at Citi, says the term risk premium is too low, while the yield curve remains too flat given the current economic backdrop. Higher yields and a steeper curve beckon, he reckons, with a 3 per cent target for the yield on the 10-year note.

A more aggressive pace of rate rises from the Fed — starting with a shift in its dot plot of future interest rate projections or hints of a reduction in its balance sheet at next week’s meeting — would throw a curveball at the foreign-exchange market, particularly investors, analysts and traders who had confidently predicted a sustained dollar rally in the aftermath of Mr Trump’s election victory.

Those predictions were rudely upended by market disappointment with the early tenor of the Trump presidency, which cast doubt on the capacity of the new administration to deliver on promises of tax cuts and fiscal stimulus.

A revival in the dollar, inspired by Fed officials putting their foot on the accelerator, would reflect how the “old driver” of monetary policy is the key factor for markets while “the fiscal issue is stage left”, says Marc Chandler at Brown Brothers Harriman.

Then, of course, there is the larger question of what a more active Fed, and a hefty rise in bond yields, means for record high equity prices and credit markets. To equity bulls, higher interest rates reflect a stronger economy and the better prospects for corporate profitability that follow.

However, a key driver of the long bull run in US equity and credit markets has been the very low level of Treasury yields. Should a captive bond market break free of the shackles of low yields, the fallout may be a lot broader than many investors currently believe.

Mr O’Donnell warns that we may be on the cusp of a “sell everything” market as the threat of a much tighter Fed drains the liquidity punchbowl, hitting equities and the corporate bond market.

The old market adage of “three steps and a stumble”, or the propensity for stocks to sell off after a hat-trick of rate increases, is one Mr Chandler recognises. But he adds that this is a Fed that is still just shifting monetary policy “from super-easy to accommodative”.

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