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“It’s Going to Be Messy” In the Bond Market (And Stocks Won’t Be Spared)

Perma-critic of the Fed’s QE, Richmond Fed president Jeffrey Lacker swung at it again, but this time against the markets that somehow seem to be willfully blind, or immersed in wishful thinking, when it comes to rising interest rates. Or maybe they simply can’t afford what rising rates would entail. Are they too painful to contemplate?

But they should contemplate it, Lacker suggested. Investors – and that would mostly be institutional investors – have been underestimating for months the speed with which the Fed will raise short-term rates, he told Bloomberg.

Fed funds futures contracts show that traders assign a 64% probability that the rate is going to be no higher than 0.75% at the end of 2015, while the median forecast issued in June by FOMC members puts the fed funds rate for the same period at 1.13%.

“When there is that kind of gap, it gets your attention,” he said. “It wouldn’t be good for it to be closed with great rapidity.”

It could get ugly if the market suddenly discovers that Fed Chair Janet Yellen hadn’t been kidding when she said in July during testimony to Congress that “increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned” [Yellen Warns Investors].

OK, there were some big IFs attached, like improvements in the labor market. Investors were skeptical of the Fed’s forecast of unemployment falling to 5.7% or lower by the end of 2015, Lacker said. And these IFs is what investors have latched on to, betting that there won’t be these improvements that would trigger the dreaded words, “sooner” and “more rapid.”

Investors may also be misled by the Fed a sanguine and much repeated phrase in the policy statement that “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”

“They may be placing more weight on that than I think it deserves,” Lacker explained. “They may think we have more conviction about that than we do.”

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