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Pimco: Markets Price Faster Interest Rate Hikes Than Fed Signals

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Markets are currently pricing in interest rate hikes by the Federal Reserve faster that the central bank itself "is signaling is likely," PIMCO Portfolio Manager and Market Strategist Tony Crescenzi told MNI.

He also pointed out that the Federal Open Market Committee's statement Wednesday at the conclusion of its two-day meeting "showed no effort to dissuade investors from speculating on a tapering of monetary policy in September, so it appears the Fed remains on the taper trail, even if dependent upon upcoming data, in particular upcoming employment data."

That being said, the calm that has returned to the bond market is likely to remain, which would support a steep yield curve, Crescenzi said.

Between early May - when the U.S. 10-year yield traded slightly above 1.60% - and early July, it jumped nearly 100 basis points.

Soaring yields triggered massive outflows from bond funds which recorded poor performances across sectors, as the Fed signaled a slowdown of the pace of its bond purchases - maintained at $85 billion a month at its latest meeting - that would come sooner than the markets had been pricing in until then.

Such a bout of volatility is unlikely to return, however, in Crescenzi's view.

"First, the storm in June reintroduced two-way price action to the bond market, and market participants have altered their positioning accordingly," he told MNI.

"Second, markets are now priced for rate hikes to occur faster than the Fed is signaling is likely, a major change from a few months ago," he continued.

"Third, the Federal Reserve has put focus on the two major anchors for interest rates: the policy rate and the inflation rate," he added.

In turn, "The greater the stability in the bond market, the more likely it is that the yield curve will retain its steepness, because short-term rates will behave in a manner consistent with stability in the policy rate, whereas longer-term rates will retain a term premium for risk in future years of an increase in the policy rate."

That increase, however, is unlikely to come until 2016, according to PIMCO's official stance.

This is "because inflation will be too low relative to the Fed's target if and when the unemployment rate reaches the 6.5% threshold that the Fed has said is the minimum level necessary for a rate hike to be considered," Crescenzi told MNI.

In fact, he pointed out that in its statement Wednesday, "the Fed put emphasis on low inflation, signaling the importance of the inflation outlook to the outlook for the policy rate."

"Inflation persistently below its 2% objective could pose risks to economic performance," the statement said in one of the few changes from the June wording.

It did add, however, that "longer-term inflation expectations have remained stable."

Going forward, however, Crescenzi said, the Fed, whose action remains data dependent, will continue to balance both the inflation and the employment mandate.

"Today, with inflation at a 50-year low, the Fed is focused more on creating conditions that promote economic growth and reduce unemployment," Crescenzi said.

On the employment front, the Labor Department reported Thursday that initial claims for U.S. state unemployment benefits fell by 19,000 to 326,000 in the July 27 week, more than expected.

This is the lowest level since the week of January 19, 2008, when it came in at 321,000.

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