Fed 'liftoff' in December: no shock, but may be market rocket fuel

By Jamie McGeever

LONDON (Reuters) - An interest rate rise from the U.S. Federal Reserve next month would surprise no-one involved in financial markets but could still drive up volatility, coming as it would in the least liquid month of the year.

Traders and investors traditionally close their books early in December before the holiday season, leaving markets far more exposed than usual to sharp moves in price.

If anything qualifies as a market-moving event, it's the Fed's first rate hike since June 2006, even though market participants have had months - some might say years - to prepare for it.

As if that's not enough, the European Central Bank is widely expected to move in the opposite direction only a few days earlier, unleashing another wave of stimulus to steer the world's second largest economic bloc away from deflation.

December is a relatively light month for trading activity across all markets, although not an especially volatile one.

Analysis of trading in 10-year U.S. Treasury futures contracts shows that volume in December 2013 fell to 70 percent of that year's monthly average, and to 86 percent in December 2014.

In German Bund futures trading over the 2011-14 period, December volumes were between 47 and 80 percent of the monthly average.

Corporate bond market activity across Europe shows a similar pattern, according to Trax, a subsidiary of electronic trading platform MarketAxess. Trax processes around 65 percent of all fixed income transactions in Europe.

It registered 163,500 trades in December 2013, which was 79 percent of that year's 206,000 monthly average. The 152,000 contracts traded in December the following year was also 79 percent of a 190,800 monthly average.

Volume reduction is even more pronounced. In December last year trades worth $125.4 billion passed across the platform, 69 percent of that year's monthly average of $182 billion.

That's the environment in which Fed Chair Janet Yellen and her colleagues on the rate-setting Open Market Committee could finally be embarking on the path towards policy "normalization".

"A lot of this has already been positioned for so it should hopefully be more of a non-event than it otherwise would be," said Scott Eaton, chief operating officer at MarketAxess Europe and Trax.

Even so, "dealers may find it difficult to take on risk positions at year-end so they try to close their books by Dec. 15. A rate rise would prompt more than the usual traffic, and it could cause some unanticipated movement in the market," he said.

RATE HIKE NOVELTY

Many financial market traders have never experienced a U.S. rate hike.

The Fed has anchored U.S. interest rates at virtually zero since late 2008, just after the collapse of the investment bank Lehman Brothers triggered the global financial crisis.

That and three rounds of "quantitative easing" bond-buying stimulus worth trillions of dollars averted another Great Depression.

The economy is now larger than it was pre-crisis and the labor market is on its longest streak of job creation in decades, with unemployment down to 5 percent.

Every time the Fed has raised rates in the past 20 years, the market was pricing in a greater than 70 percent probability, according to M&G Investments. Fed funds futures contracts show that a rise next month is currently 68 percent priced in.

A Fed hike "could lead to some higher volatility," said the chief currency dealer at a major bank in London.

"If we do get a (December) move there's not an awful lot of time left in the year to hedge that. A possible delay until January may enable the markets to digest it better," he said.

While foreign exchange is the world's most liquid financial market with around $5 trillion traded on an average day, prices could see-saw in less active areas of the fixed income markets.

Spot FX volumes on Reuters trading platforms show activity declines in December, but not vastly.

In 2013 monthly spot volume averaged $128 billion. December's total that year was $101 billion, or 79 percent of the average. A year later spot volume averaged $118 billion a month and was $106 billion in December, or 90 percent.

Stephen Jen, Managing Partner at hedge fund SLJ Macro Partners in London, said FX traders are mostly at their desks on Dec. 16 and such a widely-flagged Fed decision shouldn't disrupt activity too much.

"I'm not sure the lack of liquidity for calendar reasons will make that much of a difference. I could be wrong though," Jen said.

"We want to get it over with, get a fresh start to the year, no pent up expectations. In fact, if they don't do it in December then January would be volatile," he said.

(Reporting by Jamie McGeever; Additional reporting by Patrick Graham; Editing by Ruth Pitchford)

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