By Mike Dolan
LONDON, June 11 (Reuters) - If you were looking for signs that financial markets have overcooked the economic recovery story, one set of prices stands out like a sore thumb. Interest rate futures markets were suddenly infected this week by the three-month-old stock market rally, latching on to growing signs of a stabilisation of the ailing world econony.
So much so that at one point prices were discounting a rise of up to half a percentage point in the U.S. Federal Reserve's target interest rate this year; at least a quarter-point rise in the Bank of England's key rates by January; and a reversal of a possible autumn rate cut from the European Central Bank.
The trigger, ironically, appeared to be the May U.S. employment report last Friday. Although it recorded a loss of "only" a third of million jobs during the month, instead of the half million payroll cuts expected, it also revealed a surge in the U.S. unemployment rate to 26-year highs of 9.4 percent.
Given the Fed's dual mandate to pursue both price stability and full employment -- plus the fact it has never started a rate-rise campaign while the jobless rate was rising -- that was a brave, some may say foolish, market twist.
To be sure, futures market have calmed down a bit since, but they still point to some tightening of interest rates by all three of these central banks by January.
Yet, to put the backdrop in context, both the International Monetary Fund and the Organisation for Economic Cooperation and Development -- as recently as six weeks ago -- forecast output contractions of up to 4 percent this year for all three areas in question and none of the regions was forecast to grow in 2010.
Although markets are frequently a step ahead of official forecasters and the past month has thrown up more signs of stabilisation, will there be enough of a recovery in the months ahead to justify policies that restrict credit this year?
What makes the futures move doubly peculiar is that many analysts are also convinced the Fed will this month expand its quantitative easing programme of purchasing government bonds -- in part to put a lid on creeping long-term Treasury and mortgage borrowing rates.
A poll of U.S. primary dealers conducted by Reuters after the U.S. employment report last Friday showed seven of the 11 respondents expected the Fed to increase the size of its existing $300 billion Treasury bond purchase programme.
With any Fed rate rise almost certain to exaggerate rising long-term bond and mortgage borrowing rates, these two outlooks are completely at odds.
SQUARING THE CIRCLE
Many economists flatly dismiss the short-term rate moves.
Barclays Wealth advised its clients this week: "The spare capacity that has built up should keep price pressures subdued for longer, so we doubt rate hikes will begin this soon."
Morgan Stanley economists Joachim Fels and Manoj Pradhan told their customers on Wednesday that rate hike pricing for this year was "premature".
So, why then did futures markets move so dramatically?
The answer seems to lie in an investment world struggling with very low visibility on the medium-term economic outlook and no consensus on whether inflation or deflation will be the lasting legacy of one of the biggest financial shocks of the past century.
What they do know is central banks must end their super-easy zero-interest rate policies as soon as the recovery takes hold to prevent a supercharged money supply fuelling inflation. But they simply cannot afford to do that if the ructions caused by that very exit is likely to send the economy back into tailspin.
Predicting the turning point will be a fine call and it is virtually impossible to be confident of the timing right now.
Policymakers themselves most likely have no idea yet on the timing of their "normalisation" of policy and the uncertainty surrounding this will likely ensure some wild swings and persistently high volatility for many months to come.
Rising volatility in fixed income and interest rate swaps markets are a testament to the confusion.
Fels and Pradhan at Morgan Stanley said rising uncertainty about the macroeconomic outlook -- defined by the deviation of growth and inflation forecasts around a mean in the Survey of Professional Forecasters -- has risen to its highest in nearly four decades.
Most worryingly for central banks, uncertainty about the long-term inflation outlook over the next 10 years is at its highest level since the survey began in the early 1980s.
And the Morgan Stanley economists reckon this fog is manifesting itself in a sharp rise in the term premium -- yield compensation demanded by holders of long-term bonds for the macroeconomic risks over long maturities.
"The term premium shows a sharp rise recently and we expect this premium to stay in place, if not rise further."
And it is these elevated government bond yields, along with the resultant boost to long-term mortgage and corporate borrowing rates, that may themselves be enough to rein in runaway speculation of a sudden return to world growth. (Editing by Ruth Pitchford)