Rising volatility in U.S. interest rates is seen in coming months as traders expect the Federal Reserve to move away from its near-zero interest rate policy held for the past six years.
Several measures of interest rate volatility have climbed from historic lows reached in recent weeks to levels not seen since mid-summer with various indicators such as Merrill Lynch's benchmark for bond market volatility pointing to choppier days ahead for U.S. interest rates and bond yields.
Traders say a more volatile climate for U.S. interest rates, if sustained, may create more turbulence for other markets as well, as traders profit from long-term bets financed by cheap borrowing costs. Volatility has been rising in the currency market as well, with some analysts expecting it to bleed into other markets on expectations of a more hawkish Fed.
"We are shifting toward a different tilt with the Fed. How will the Fed manage an exit?" said John Herrmann, director of interest rate strategy at Mitsubishi UFJ Securities USA in New York. "Because of that uncertainty, it makes sense for volatility to come off these lows."
Through three rounds of bond buying designed to boost the U.S. economy, the Fed has amassed a balance sheet of nearly $4.4 trillion of assets and has driven bond yields, which move in the opposite direction of their prices, to historic lows.
Bank of America Merrill Lynch's MOVE index on one-month U.S. rate volatility rose to 66.30 on Monday, its highest since April 2.
Its three-month and six-month volatility gauges hit their highest levels since early February and mid-March on Friday before retreating on Monday. Meanwhile, the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index briefly touched its highest level since late July earlier Tuesday before ending 0.6 percent lower on the day at 5.25.
There is a growing view that U.S. policymakers might signal their intention is to embark on a "lift-off" in short-term rates as early as the middle of 2015 at its next policy meeting.
While the U.S. economy is far from robust, there is some evidence it might not require exceptional low interest rates from the Fed.
The Federal Open Market Committee, the Fed's policy-setting group, began a two-day meeting on Tuesday. It is expected to release a statement on their view on the economy and monetary policy at 2 p.m. on Wednesday.
Concerns about the Fed raising rates have spurred a sell-off in the U.S. bond market, propelling shorter-dated yields to their highest in nearly 3-1/2 years last week .
However, if the FOMC refrains from signaling it is moving closer to interest-rate increases, the bond market could rally and push volatility back toward historical lows, analysts said.
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