Fed won't hike rates because they're too scared: Economist

Why the Fed won't raise rates

Wall Street breathed a sigh of relief last week, as the Federal Reserve held off on raising interest rates. However, one top bond watcher says investors need not worry about upcoming rate increases, because the Federal Reserve is actually scared that any such action would throw global bond markets into turmoil.

In a recent interview on CNBC's Fast Money, Citigroup's Head of North America Economics William Lee said the concerns about a lack of liquidity in the fixed income markets would sideline any Fed action for the foreseeable future.

"The Fed's trying to reassure everybody that they're going to do things nice and slow, nice and gradual...but one of the things that I'm worried about is what's happened to the bond market since the crisis," said Lee.

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According to Lee, new regulations intended to bolster the safety of the financial system have actually had the opposite effect. In his view, new rules have prevented banks from making markets in a number of fixed income assets, leaving fewer buyers and sellers of bonds.

That could leave the bond market vulnerable to "very severe bumps" if the Fed raised interest rates—something many expect it will do later this year.

Lee isn't alone in his analysis. After the Federal's Open Market Committee left rates unchanged last week, Peter Boockvar, managing director at The Lindsey Group, noted that the Fed "is again punting on any commitment to the timing of raising rates, maybe because of the imminent news on Greece." The Hellenic Republic's debt turmoil has whipsawed markets, and left many investors on edge wondering about the potential fallout.

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That also means the Fed is stuck trying to manage expectations—and concerned about tightening too quickly. According to Lee, in order to avoid a rocky period of rate increases, the Fed needs to ensure the bond market has enough capacity to absorb the blow.

"People want to get it ahead of any rate increase. So the Fed can reassure everybody that things are going to be very very slow," he added.

All these factors has Lee convinced the Fed won't take any action until at least December, despite its strong desire to move rates from zero. Still, he thinks the Fed would need to convince investors the hike will be gradual to avoid a so-called "taper tantrum"—or a sharp sell off in bonds—similar to the one experienced in mid-2013.

If the Fed did this, Lee said, it would allow investors to get ahead of the curve and lower the risks of disrupting the equity markets.

The economist added that this fear of bond market volatility spilling over into equities is another factor that is preventing the Fed from taking action. With rates steady at zero since late 2008 – the longest stretch in history – equities have been somewhat of a safe haven for investors.

"I think the equity market is a place that people have gone to for liquidity" he added.