THE US bond market may play down the chance of interest rate rises arriving this summer; not so Janet Yellen.

The chairwoman of the US Federal Reserve has signalled that the central bank desires greater flexibility in terms of ending its current policy of maintaining near-zero borrowing costs, introduced more than six years ago during the depths of the financial crisis.

But with the US economy generating solid job gains, and the creation of more than 1m positions since November, the stars are aligning for a normalisation of interest rates that could arrive in June and not later in the year, as forecast by the bond market.

The dawning prospect of the first US rate rise since 2006 remains a significant point of uncertainty for how markets perform this year. The bond market has long reflected a view that rate increases will be gradual and limited in scope, with investors focused on falling inflation pressures and an uncertain global backdrop.

Indeed solid demand for new two-year notes sold after the latest Fed testimony on Tuesday resulted in the policy-sensitive yield dropping back below 0.6 per cent, illustrating how the bond market remains sanguine about the risk of rate rises. Meanwhile the S&P 500 reached a record closing high, with markets soothed by the Fed chief’s emphasis that any shift away from saying policy had to remain “patient’’ would not signal an imminent rates lift-off.

Ian Lyngen, strategist at CRT Capital, says the Fed can remove the word “patient” from its policy statement at next month’s meeting, without necessarily “signalling that tightening is a ‘couple’ of meetings away”. Once the Fed drops its patient stance, however, rate rises could well arrive this summer if wage growth pick up and other indicators improve.

Summer of volatility on cards if US central bank acts sooner than debt traders assume

Alan Ruskin, strategist at Deutsche Bank, says: “Once you enter a tightening phase, flexibility becomes important. The door to a hike in June is open, even if she [Yellen] has not shown she plans to walk through it.”

The Fed chairwoman played down falling inflation and excess capacity, suggesting that policy remains on hold for much of this year, and focused on the likely boost in growth from lower oil prices and a strengthening jobs market.

A long period of rock-bottom borrowing costs and vast purchases of Treasury bonds by the Fed via several rounds of quantitative easing have spurred investors to embrace equities and own long-maturity bonds, confident in the belief that the risk of sharply higher interest rates, which would deeply unsettle markets, remains low.

“QE led to a lot of money flowing into the US market, and now the concern is that we see flows reverse,’’ says Ashish Shah, head of global credit at AllianceBernstein. ‘’The Fed has a tough hand here. Purely on US data, they should go, but they see threats from the global economy. Russia and Greece are tail risks for investors.”

Global concerns and low long-term market estimates of inflation have supported a divergence over the extent of rate increases between the Fed and bond investors. A central bank looking to push overnight borrowing costs beyond 1pc by the end of this year continues encountering scepticism from a market that expects a level of about 0.5pc. That gap may well narrow next month when policy makers release updated forecasts, with the Fed expecting a funds rate below 1 per cent.

Still there is a concern in some quarters that the bond market remains too focused on falling inflation and global worries, and has underplayed the prospect of a stronger domestic economy that is at odds with overnight rates anchored near zero.

“The base case for the Fed remains at least two or more rate hikes, and that’s a problem for a market that believes the inflation and debt story will limit such a change in policy,’’ says Eric Green, economist at TD Securities. “If you look at long-term inflation expectations, the bond market says the Fed will not reach their inflation target.”

A volatile summer could well ensue: should the Fed decide to act sooner than assumed by bond traders.

Additional reporting by Tracy Alloway

Published in Dawn, Economic & Business, March 2nd , 2015

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