Bond traders brace for more turbulence in short-term treasuries

[NEW YORK] What a difference a week makes for bond traders betting on when the Federal Reserve will raise interest rates.

The probability of an increase in September surged as high as 58 per cent on Friday from 38 per cent on Monday, after data showing sustained labor-market growth in July and comments from Atlanta Fed president Dennis Lockhart suggesting US economic strength may merit a rate increase next month. After yields on Treasury two-year notes rose the most in six weeks, traders are paying more to protect against price swings in those securities, which are susceptible to changes in the outlook for Fed policy.

"We're going to continue to be extremely sensitive to each data point we get, and each bit of Fed speak," said Michael Lorizio, a Boston-based fixed income trader at Manulife Asset Management, which oversees US$20 billion. "It's almost an exaggerated focus."

The two-year yield rose six basis points this week in New York, or 0.06 percentage point, to 0.72 per cent, according to Bloomberg Bond Trader prices, the largest weekly increase since June. The rate-increase forecasts are based on the assumption that the Fed funds rate will average 0.375 per cent after the first increase.

Traders are paying 6.2 per cent more to protect against swings in two-year notes than they were a week ago, according to options prices. While the Labor Department's July employment report is out of the way, economic data to be released next week may further change views on the timing of the Fed's first rate increase since 2006.

One potential catalyst for short-term Treasury swings is retail sales data due to be released Aug 13. Economists surveyed by Bloomberg predict sales rose 0.6 per cent in July from the previous month. A strong report may give the Fed more ammunition for a September increase.

Strategist George Goncalves said he is skeptical about a September increase, but that a robust report could sway him.

"If retail sales are strong and inflation turns a corner, I could change my view," said Mr Goncalves, New York-based head of interest-rate research for Nomura Holdings.

Mr Lockhart, who's a voting member of the Fed's policy-setting committee, will speak on Aug 10 at a Fed Bank of Atlanta conference and at the Atlanta Press Club. He could walk back or confirm the view he expressed last week that the US economy is ready to support higher borrowing costs.

"The move up in yields was fully a Lockhart trade," said David Keeble, the New York-based head of fixed-income strategy at Credit Agricole.

Traders will also be trying to determine whether the Fed may be delayed by the latest drop in oil prices. Falling energy prices have suppressed a bond-market inflation forecast known as the break-even rate. That has helped long-term Treasury prices, which are more sensitive to inflation and economic growth.

"If we see financial conditions worsen and the global backdrop is bad, absolutely, they'll wait" to raise interest rates, said Mr Goncalves. "People are on pins and needles, and really trying to take stock in the lead-up to the September meeting."

BLOOMBERG