Is Wall Street Poised for Taper Tantrum 2.0?

Investors may be ignoring subtle warnings from the Federal Reserve that a rate rise may come sooner than they think, setting the stage for another painful market contraction much like last year's "taper tantrum."

Catching investors off guard is the last thing U.S. central bankers want to do, which helps explain their repeated recent warnings over complacency in financial markets, and Fed Chair Janet Yellen's pointed comments this week about banks and others building up dangerous "interest rate risk."

Yet many Wall Street economists, skeptical that the economy will finally break out of its recessionary funk, do not believe the Fed will tighten its extraordinarily easy monetary policy as soon or as aggressively as its forecasts suggest, surveys consistently show.

U.S. bond markets also have shown little sign of prepping for a rate hike. Meanwhile most Fed policymakers have been surprised by the sharp drop in unemployment and pleased by signs that inflation is firming. They are wrapping up an asset-purchase program and starting to detail exactly how they plan to raise rates from near zero.

"I don't think people have really internalized how rapid the decline (in unemployment) has been," St. Louis Fed President James Bullard said in an interview.

If strong jobs growth continues, and if economic growth bounces back from a decline in the first quarter, "there will be a lot more talk about an earlier date of possible liftoff."

Bullard has warned that the Fed is now closer to its inflation and unemployment goals than at any time in about a decade. Hawkish relative to most colleagues at the Fed, he wants to see a rate rise in the first quarter of next year, about four months ahead of the market. And he is not alone: on Wednesday, Richard Fisher of the Dallas Fed said rate hikes are "likely" early next year. [ID: nL2N0PR1IX]

"There can be volatility in markets, and sometimes there is kind of a realization that an existing view is not panning out ... and there is a sudden adjustment in markets," Bullard told Reuters. "One of the good things about talking about the economy every day and reassessing the data every day is you get that process to be more gradual."

Based on futures trading at the CME, investors have been fixated for most of the year on July 2015 for a small rise in the key federal funds rate. The chance of a March rate rise, in their view, has hovered around 20 percent.

While Fed policymakers generally expect rates to have risen to 1-1.25 percent by the end of next year, primary dealers surveyed by the New York Fed last month pegged it at only about 0.63 percent by that time.

"We know from the past that economic recoveries come quick and furious," said William Larkin, fixed income portfolio manager at Massachusetts-based Cabot Money Management, which manages $500 million. He said he is repositioning for more economic strength, with the yield on the 10-year rising to about 3 percent in the next few months from about 2.5 percent now. "When this unwinds, it's going to hurt investors," he said.

ON THE SAME PAGE

The Fed's nightmare is a recurrence of last spring, when U.S. mortgages and other borrowing costs shot up after then-Chairman Ben Bernanke talked about the prospect of reducing bond purchases "in coming meetings."

The so-called taper tantrum also slammed emerging markets as investors priced in an earlier tightening cycle, compelling several of Bernanke's colleagues at the Fed to walk back the importance of his comment. But the damage to the economy, and the central bank's reputation, was done.

This time, Yellen, whose reputation will hinge on how smoothly she can reverse the world's biggest-ever experiment with monetary stimulus, wants investors and the Fed to be on the same page as the first U.S. rate hike since 2006 approaches.

"We are attentive to risks that can develop in this environment," she told a Senate committee on Tuesday, "and when interest rates ultimately begin to rise, that if firms or individuals have taken risks and aren't prepared to deal with them that can cause distress."

Yellen stressed the current continuing need for accommodation and said policy would respond to the economy, as usual.

But she subtly shifted her tone, saying that the Fed could raise rates sooner "if the labor market continues to improve more quickly than anticipated." In June, she sounded more tentative, promising faster rate hikes "if the economy proves to be stronger than anticipated."

HEADING TOWARD GOALS

Indeed, U.S. employment looks better now than most policymakers or economists had expected.

The unemployment rate fell to near a six-year low of 6.1 percent in June and payrolls jumped by 288,000, having averaged 231,000 per month this year. The report prompted JPMorgan and Goldman Sachs to shift forward their predictions of the first Fed rate rise, but even those top banks don't see it happening until the third quarter of next year.

To be sure, some officials say the Fed can and should keep rates low even if the labor market continues its upward climb, so long as inflation looks set to stay around target. That's the view of Chicago Fed President Charles Evans and Minneapolis Fed President Narayana Kocherlakota, who said last week that "no one's going to be criticizing us if employment gets too high ... as long as inflation is too low."

Caution is also being preached from abroad.

IMF Managing Director Christine Lagarde has not been shy to recommend that the Fed only gradually raise rates, often citing the taper tantrum as the example to be avoided for the harm it brought on the stocks and currencies of countries such as India, Turkey and Argentina.

But the Fed's remit is the U.S. economy, where inflation is slowly edging higher.

Even though the main gauge watched by the central bank continues to run below its 2 percent target, in the 12 months through June the key measure of U.S. producer prices increased 1.9 percent after having risen 2.0 percent in May.

And while growth sharply contracted in the first quarter, hurting prospects for the full year, by law the Fed aims for stable prices and maximum sustainable employment.

"Growth is not part of the Fed's objectives," Cornerstone Macro partner Roberto Perli wrote in a note. "If potential growth is lower, the Fed will achieve its goals with lower growth."