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Why markets are still not ready for the Fed to hike

With most investors anticipating U.S. rates to move off historically low interest rates for the first time in nearly a decade in December, there are some market-watchers who are still worried. Not about what the rise will be, but the pace of increases after that first move.

Much has been written about the "dot plot" or the Federal Reserve Open Market Committee's (FOMC) expectations of how quickly it expects the Fed funds rate to climb in the longer term.

Trader on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Trader on the floor of the New York Stock Exchange.

After September's Fed policy meeting, the dot plot, which is not an official policy tool, pointed to the members moving to a much more dovish view of future rate rises compared to earlier forecasts. But analysts are warning that investors are still at risk of being caught out by the pace of rate rises next year, particularly in U.S. government bonds and the dollar.

Global chief investment officer of fixed income at HSBC asset management, Xavier Baraton, said as the Fed is gearing up to normalise interest rates, real yields (or yields after inflation) have been factored and are likely to go above the 1 percent bar. This translates to closer to 3 percent rather than 2.25 percent yield on 10-year U.S. Treasurys.

"It leaves us very cautious on U.S. rates as a result. Especially as the rate hikes are not necessarily priced in next year, not enough or very few of them," Baraton said in an investment update call with clients and journalists.

"The market is behind the curve or a little bit complacent. They think the Fed will stick to a very slow place and our view is that as headline inflation bounces back in the first half of 2016 as a result of the base effect of energy prices, we could also see wages and core inflation creep up even more visibly," he said.

This will leave the Fed a little more exposed and the U.S. curve more vulnerable with a particular impact on intermediate maturities, or 3-10 year bonds, he added.

Long dollar trouble?

Investors who are long U.S. dollar, or those that anticipate further strength in the greenback, are also at risk after the meeting, according to analysts -- but only if the pace of rate hikes ahead points to a "flat path" rather than a steep one.

"Historically, the first hike has often led to the dollar losing some of its strength. Whether we see dollar weaken this time round, though, is a question mark, since other central banks will probably take a while longer before they start to raise interest rates," said head of fixed income at GAM in Zurich, Enzo Puntillo.

Fund managers polled by the Bank of America Merrill Lynch said long dollar was the most crowded trade in markets earlier this month, with the greenback trading close to an 8-month peak against a basket of currencies this week, ahead of the possible move from the Fed next month.

The big number markets are waiting for is the November employment report on December 4, after October's report of 271,000 nonfarm payrolls and a surprise pickup in wages. That report will have direct bearing on the Fed's rates decision December 16.

"Investors should not wait until FOMC to take profit. It is pretty clear that the Fed will deliver a dovish hike. Even if your inclination is hawkish, December 17 is not the time for a display of hawkish personality, given that what is now and likely to be priced on December 15 is a very flat path," said global head of G10 FX strategy at Citi, Steven Englander.

Top Fed officials have insisted that rate hikes will be gradual and shallow. Atlanta Fed President Dennis Lockhart said he is "comfortable with moving off zero soon," but added that the pace of increases may be "somewhat slow and possibly more halting than historic episodes of rising rates," in a speech last week.

"If you are long dollars right now the FOMC has no incentive to please. In fact, if the dovish hike could weaken the dollar, there would be few on the Fed who would object," he added.