April 9, 2018 / 7:04 PM / 14 days ago

Rate swaps show concerns about Fed policy mistake: JPMorgan

(Reuters) - The forward curve of swaps based on Federal Reserve rate expectations has inverted slightly, indicating that market participants are concerned about the U.S. central bank making a policy mistake, analysts at JPMorgan said in a report.

FILE PHOTO: The Federal Reserve headquarters in Washington September 16 2015. REUTERS/Kevin Lamarque/File Photo

The forward curve of the one-month overnight index swap (OIS) rate has inverted slightly after the first quarter of 2020, implying an expectation that the Fed will cut rates after then, JPMorgan said in the report sent on Friday.

“An inversion at the front end of the U.S. curve is a significant market development, not least because it occurs rather rarely. It is also generally perceived as a bad omen for risky markets,” analysts including Nikolaos Panigirtzoglou said.

The two most likely explanations for the inversion is that markets are pricing for a Fed policy mistake, or for end of cycle dynamics, with a central bank mistake seen as more likely based on fund flows.

Flows into equity funds have turned slightly negative, after a strong start to the year, and interest rate sensitive sectors including real estate investment trusts (REITs) have seen outflows, which supports the hypothesis that investors are concerned about Fed policy.

Government bond exchange traded funds (ETFs) have also seen steady inflows while inflows into inflation-linked government debt ETFs have slowed, adding to the idea that there is concern about a central bank error.

Concerns about Fed policy would show as fears about earlier growth weakness and be marked by weak equity flows, greater flows into longer-dated bond funds than shorter-dated ones and weak flows in interest rate sensitive sectors.

End of cycle dynamics, on the other hand, would be reflected as overheating and inflation fears, which would boost flows into inflation-linked funds, shorter-dated bond funds and into cyclical sectors and equity funds in general.

Supporting the end of cycle thesis is that recent equity inflows have focused on cyclical sectors and outflows have been in more defensive sectors, and that inflows into short-term and floating-rate bond ETFs have outpaced those of long-term bond funds, JPMorgan said.

Reporting By Karen Brettell; Editing by Chizu Nomiyama

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