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MONEY MARKETS-Markets fret Fed rate hikes, tapering are coming closer

(Adds new analyst comment, euro/dollar cross-currency basis swaps)

LONDON/NEW YORK, Jan 11 (Reuters) - Money markets have ramped up bets on U.S. interest rates rising in 2023, sending a shudder through global equities which may soon have to brace for the day the Federal Reserve starts scaling back aid to the economy.

The Democrat “Blue Sweep” of Congress and White House almost certainly means more government spending, potentially accelerating economic recovery and inflation.

With U.S. President-elect Joe Biden promising “trillions” in extra spending, U.S. 10-year Treasury yields are above 1.10%, a 9-month high, having ended the year around 0.91%.

Some now reckon the Fed may start unwinding - or tapering - its $120 billion a month asset-purchase programme by the end of the year, paving the way for more than one quarter-point interest rate hike in 2023.

Eurodollar futures maturing in September 2023 on Monday are fully pricing in a 25-basis point hike by that time frame.

The futures are a bet on the direction of the short-term London interbank offered rate (LIBOR), one of the most widely used interest rate benchmarks in global financial markets. Investors hedge interest rate risk in the eurodollar market.

The shift was accompanied by higher trading volumes, implying a broader change of thinking is under way - turnover on June 2023 futures contracts saw their third biggest volume day ever on Friday.

“Bond markets are bringing forward the timing of the first Fed rate hike, even if people are getting a bit carried away over the fiscal stimulus from Biden,” said Thomas Costerg, senior economist at Pictet Wealth Management.

He sees the eurodollar futures shift as an over-reaction, given the challenges faced by the economy grappling with COVID-19 and expects the first rate hike only in 2025.

Gennadiy Goldberg, senior rates strategist, at TD Securities in New York agreed with Costerg’s assessment.

“We think the pulling forward of rate hike expectations is somewhat overdone as it will take some time for the Fed to recover to normal and for inflation to notably overshoot their 2% mark,” Goldberg added.

Investors jumped on the reflation bandwagon in November, betting the world economy would return to growth in 2021 thanks to COVID-19 vaccines and Biden’s presidential election victory.

Those bets gathered steam in the opening days of 2021 as Democrat wins in the Georgia Senate run-off sent Treasury yields soaring despite weak economic data.

Eurodollar futures contracts maturing December 2022 show the first signs of changing expectations on U.S. rates, pricing 10 bps of rate increases by then, compared to no changes until last week.

Those moves contributed to stock market losses on Monday, with world stocks falling 0.7%

TASTE OF TAPER TANTRUM?

Well before any rate hikes, the Fed will have to cut back its asset purchases, reducing the flow of liquidity into markets. It was such fears that ignited a weeks-long equity and bond market selloff in 2013, the so-called taper tantrum.

Tapering may commence by end-2021, Deutsche Bank said, noting the Fed could signal its tapering intentions in June “if they are convinced that the vaccine rollout is proceeding well and growth is getting back on track before a gradual taper in December.”

Morgan Stanley expects this to happen from January 2022, predicting government debt purchases to be tapered by $10 billion, mortgage-backed debt by $5 billion at every meeting with an aim to completely stop purchases by 2023.

In itself, tapering won’t lead to rate hikes but it would boost yields, a challenge for markets with elevated valuations.

“The story in equity markets is about the spread between corporate earnings yields and 10-year Treasury yields,” Pictet Wealth’s Costerg said.

“One leg of the equation - interest rates - was fixed, but now people fear it may be starting to move.”

In the cross currency swaps market, the cost of exchanging three-month euros into dollars was 9.625 basis points on Monday, suggesting that dollar demand has eased offshore. Euro/dollar three-month swaps widened to as much as 36.875 basis points in favor of the dollar on Dec. 22, its largest margin since mid-March 2020, due to cyclical year-end demand for the U.S. currency for balance sheet purposes.

Reporting by Saikat Chatterjee in London and Gertrude Chavez-Dreyfuss in New York; Additional reporting by Dhara Ranasinghe; Editing by Sujata Rao and Toby Chopra

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