September 30, 2023

Bond traders brace for Fed meeting full of wildcards, risks

(Bloomberg) — The risks to bond investors from next week’s Federal Reserve meeting go far beyond whether officials decide to raise rates again.

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For a market betting that the central bank will cut interest rates fairly quickly, the updated quarterly forecast for policy rates and key economic indicators – expected to be released alongside the interest rate decision on Wednesday – will be at least as important.

The interest rate decision is, of course, critical, especially as traders remain divided on whether a June or July hike is more likely. But there’s more to policy direction beyond that point.

The Fed is adamant that it is premature to think about rate cuts this year, and traders don’t expect more than one. Still, there are plenty of bets in options and elsewhere that an economic slowdown will require lower borrowing costs.

So the economic projections of Federal Open Market Committee members and Chairman Jerome Powell’s tone at his post-decision press conference may shape the reaction more than the timing of the next quarter-point hike. If they suggest conditions are peaking, bets on a pivot would increase, while a more robust and aggressive set of forecasts would boost bets on higher-for-longer rates.

“The market is positioned for a long-term rally,” said Meghan Swiber, interest rate strategist at Bank of America Corp. that the Fed is done with the walking cycle.”

Asset managers who favor long-term government bonds or position themselves for a steeper yield curve are anticipating the end of the Fed’s rate hikes, Swiber said. Bank of America’s most recent monthly investor sentiment survey found exposure to the US dollar duration reached its highest level since 2004, after surpassing the April 2020 pandemic highs.

Swap contracts tied to future Fed meetings — which were almost fully priced in a quarter-point increase in June at the end of May — have lowered that outcome to about one in three — still an unusual lack of consensus so close to the event. The Fed has hiked rates 10 consecutive times since March 2022, and in all but two cases there was little doubt about the likely outcome of swap prices.

The July contract’s rate of about 5.31% is about 23 basis points higher than the 5.08% level of the Fed’s interest rate target, with a 25 basis point increase almost fully factored in by then. For December, the contract rate is 5.07%, with any rate increase expected to be reversed by a quarter point from current levels by the end of the year.

“The Fed is pretty much done even if they go one or two more times,” said Arvind Narayanan, senior portfolio manager at Vanguard Group Inc. slows down enough to keep rates at 5% for the rest of the year, after which the Fed eases slowly next year.”

What Bloomberg’s strategists say

“It is indeed rare for the Fed to tighten policy again after a pause. It is even rarer when tariffs are already restrictive.”

— Simon White, macro strategist

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Inflation data released early Tuesday could prove decisive. The growth rate of the consumer price index is expected to slow to 4.1% in May from 4.9%, and to 5.2% from 5.5% excluding food and energy. The Fed aims for an inflation rate of 2% on average over time.

Economists at Citigroup Inc., who expect a rate hike in June, are basing that forecast on May CPI readings that they believe will show underlying inflation to remain closer to 5%, Andrew Hollenhorst, chief U.S. economist at the bank, said. in a video released Thursday.

Prior to the meeting, signals from the Treasury market could be biased by an unusually large amount of new supply compressed into two days. In addition to monthly sales of 3- and 10-year bonds and 30-year bonds, normally spread over three days, $206 billion in Treasury bills will be sold to replenish the government’s coffers, which had been depleted to the federal debt limit previous week suspended.

Expectations for more rate hikes by the Fed peaked in early March this year, when Powell said policymakers were willing to accelerate the pace of rate hikes again if economic data warranted it. Two-year Treasury yields, which are more sensitive than longer maturities to changes in Fed interest rates, briefly hit 5%. It has stabilized at around 4.6% as pleas for more rate hikes have been tarnished by several regional bank failures and other signs that the economy can finally factor in tighter financial conditions.

“We think the Fed is more likely to skip July,” said Thomas McLoughlin, head of fixed income for the Americas at the UBS Group’s asset management arm’s principal investment office. “But the message from Powell was that his intention is to maintain tight monetary policy at least through the end of the year and possibly into next year.”

What to watch

  • Economic data calendar

    • June 12: Monthly Budget Review

    • June 13: Consumer Price Index; NFIB Small Business Optimism

    • June 14: MBA mortgage applications; manufacturer price index

    • June 15: retail sales; unemployment claims; import and export price indices; Empire production; Philadelphia Fed Business Outlook; industrial production; business inventories; Treasury international capital flows

    • June 16: New York Fed business activity; U. of Michigan Sentiment and Inflation Expectations

  • Federal Reserve calendar

  • Auction calendar

    • June 12: 26 and 13 week bills; 3 and 10 year bonds

    • June 13: 52-week bills; 42-day cash management accounts; 30-year bonds

    • June 14: Bills of 17 weeks

    • June 15: 4 and 8 week bills

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