Bond traders are waving off protestations that the Federal Reserve might have one more hike up its sleeve and are increasingly convinced that the US central bank’s next move will be to cut its benchmark as recession risks mount.
(Bloomberg) — Bond traders are waving off protestations that the Federal Reserve might have one more hike up its sleeve and are increasingly convinced that the US central bank’s next move will be to cut its benchmark as recession risks mount.
Treasuries surged Wednesday, led by intermediate and shorter-dated securities, as investors reinforced bets that Fed rates will be lower by the end of this year despite Chair Jerome Powell’s insistence that the central bank’s inflation outlook doesn’t support easier policy. The so-called bull-steepening move took the gap between 5- and 30-year yields to a level last seen in early 2022 even as the Fed lifted its benchmark by a quarter point to a range of 5% to 5.25%.
The rates market briefly entertained the risk that the Fed could push its benchmark higher again next month, at one point boosting the odds of a quarter-point hike to more than one-in-five as Powell spoke at his post-decision press conference. But that totally reversed by the end of the day and even swap contracts for June are now pointing to the effective fed funds rate being lower.
“There are too many hurdles now to hike and the markets know it,” said George Goncalves, head of US macro strategy at MUFG Securities. “Powell didn’t really push back hard enough on cuts.”
Concern about the state of US banks added to the impetus for lower Treasury rates late Wednesday, with news emerging that regional lender PacWest Bancorp. has been weighing a range of strategic options, including a sale.
The three-year Treasury yield fell as much as 17 basis points on the day to 3.50%, reaching its nadir close to the day’s close, while the 10-year benchmark closed 9 basis points lower at 3.34%.
With the ever-important monthly jobs report still to come later this week and consumer-price inflation numbers next week, the swaps market is suggesting that Powell and his colleagues have probably finished tightening.
In addition to those major macro indicators, investors will also be keenly attuned to developments in the banking sector, which has already witnessed a string of major failures, and the development of credit conditions. Particular focus will be trained on the Fed’s senior loan officer survey Monday, which may confirm that further lending constraints are taking place.
The Fed is “clearly worried about tighter credit conditions’ impact on the economy,” said Priya Misra, global head of rates strategy at TD Securities. “The curve is bull steepening as the market is pricing in more rate cuts in 2024.”
Right now, swaps for the Fed’s December meeting imply more than three quarter-point interest rate cuts by the end of 2023, with more reductions beyond that.
The sharp resteepening in the Treasury curve between the 5- and 30-year maturities reflects greater confidence in rate cuts. The five-year yield is trading some 38 basis points below the rate on the 30-year bond, a level it last closed at back in early 2022 when the central bank began the job of dragging its policy rate up from near zero.
“As the central bank pivots to a holding stance, with potential cuts in the future, we think this is broadly positive for rates,” Greg Wilensky, head of US fixed income at Janus Henderson Investors said in a note. “In time, we would expect the yield curve to steepen from current levels.”
With some cloudiness over when the Fed might officially indicate it’s on pause and until employment and inflation date both slow a lot more, sticking with a 5- to 30-year steepener trade is an attractive way for some bond investors to bet on the risk of a painful recession later this year.
The steepening trend may well “chop for a bit” but the direction of travel is clear, said MUFG’s Goncalves. “The steepening just takes over from around here, the big curves start steepening more and don’t look back when they do.”
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