Federal Reserve faces growing pressure to raise rates.

bloomberg/chinapost
In the options market where the savviest investors take apart conventional wisdom, the Federal Reserve is facing growing pressure to consider raising interest rates as soon as December.

Options on Federal Fund futures at the Chicago Board of Trade indicate a 41 percent chance the central bank will lift its target rate for overnight loans between banks to 5.5 percent from the current 5.25 percent, according to data compiled by Bloomberg. A month ago, they showed no expectations for an increase.

While the economy expanded at the slowest pace in more than four years in the first quarter, inflation remains at the top of the Fed's comfort zone, business activity has rebounded, the jobless rate is near the lowest in six years and stock indexes are setting record highs. Just three months ago, options traders speculated the weakest housing market in 16 years would force the central bank to cut interest rates to 4.5 percent by January.

"The economy is in better shape than people give it credit for," said Jamie Jackson, who oversees government debt trading at RiverSource Investments in Minneapolis, which manages US$100 billion of bonds. "People exaggerated the pass-through effects of the housing weakness. If the Fed were to do something by year-end it would be a tightening."

The chance of at least one cut in the overnight lending rate between banks has fallen to 29 percent from 83 percent since the start of May, options prices show.

Federal Reserve policy makers "have started to tell us in pretty consistent language they're not satisfied at being at the upper band" of their inflation target, said Stan Jonas, who trades interest-rate options in New York at Axiom Management Partners LLC. "One-third of the people think the next move is going to be a tightening."

Options more accurately reflect changes in monetary policy than futures contracts, the most widely used barometer, because they include the widest array of wagers, according studies by the Federal Reserve Bank of Cleveland in 2005 and the Federal Reserve Bank of St. Louis in 2006.

The Cleveland Fed paper has influenced the study of monetary policy expectations and follows a "perfectly sound procedure," said James Hamilton, an economics professor at the University of California, San Diego.

The CBOT first listed the options in 2003 and began offering contracts in July that allow bets on the Fed's target rate. The so-called binary options pay US$1,000 if an investor bets correctly on the Fed's interest-rate decision at regularly scheduled meetings. Investors get nothing if they bet wrong.

Treasury yields climbed last week to the highest since August. The yield on the benchmark Treasury note due in May 2017 rose 9 basis points, or 0.09 percentage point, to 4.95 percent. Its price fell about 23/32, or US$7.19 per US$1,000 bond, to 96.15.

Treasuries returned 1.1 percent so far this year, compared with a 1.5 percent loss last year, according to indexes compiled by Merrill Lynch & Co.

Personal spending on items excluding food and energy, the Fed's preferred inflation measure, rose 2 percent in April, at the top of the central bank's preferred 1 percent to 2 percent range. It had been above 2 percent the previous 12 months.

Central bankers reiterated their forecast for faster growth and said "downside risks" to the economy have "diminished slightly," according to minutes of the May 9 Federal Open Market Committee meeting released last week.

"Economic growth will pick up as we move through the year," Federal Reserve Governor Randall Kroszner said at a June 1 conference in Athens. "The risks to the inflation outlook are primarily to the upside."

Merrill Lynch & Co., Goldman Sachs Group Inc. and UBS AG, among the biggest bond bulls this year, have yet to change their forecasts for the Fed after predicting a housing-led recession would result in at least three rate cuts this year. Merrill and Goldman are based in New York and UBS is in Zurich.

New home sales rose 16 percent in April to an annualized rate of 981,000, according a Commerce Department report released May 24. Analysts attributed the increase to developers reducing prices of unsold houses. The average selling price dropped 10 percent, the report said.

Gains in stocks that pushed the Standard & Poor's 500 index to a record 1535.56 on May 30 discouraged the Fed from cutting rates, said David Rosenberg, chief economist for Merrill in New York. Rosenberg predicted at the beginning of January that rates would fall to 4.25 percent this year. He declined to specify when the Fed will cut rates in an interview May 30.