The Fed’s “higher for longer” mantra raises doubts in the bond market

By | September 17, 2023

(Bloomberg) — Amid signs that the bond market has accepted the Federal Reserve keeping interest rates higher for longer, a group of investors is betting on the economy hitting a wall — and a sharp policy reversal in short time.

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Treasury yields have settled in narrow ranges this month, near their highest levels in more than a decade, as data shows a resilient economy and inflation still well above the Fed’s 2% target But with yields anticipating a peak in the policy rate, growth prospects take on greater importance.

Last week saw a resurgence in demand for options that will pay off if interest rates fall before the middle of next year. This is a more dire scenario than that seen in the swap market, where traders are no longer pricing in a rate cut during the first half of 2024.

Bond traders have been placing these types of bets since the start of the rally cycle and so far they have been unsuccessful. But this time could be different as the Fed’s tightening cycle has had more time to act on the economy.

The Fed is expected to leave its key rate unchanged next week, after raising it in July for the tenth time in an aggressive rate hike that began in March last year. It was also seen significantly raising its growth forecast and pointing to another rate increase this year in its so-called dot plot. The rate outlook for 2024 remains a matter of debate. In June, the median projection showed a full percentage point cut by the end of next year.

Longer rates remain elevated, as does the risk of a downturn, and at the margin there are more signs of consumer stress as higher borrowing costs and weaker hiring begin to erode household spending. With the Fed close to peaking its policy rate, attention is now turning to weakening growth.

“There is a question mark over whether the economy is transitioning to a soft landing or whether the labor market is weakening towards a more recessionary outlook,” said Roger Hallam, global head of rates at Vanguard Asset Management.

The week saw notable demand for options tied to the secured overnight financing rate – which closely aligns with the expected path of the Fed’s key rate – to hedge multiple rate cuts ahead of June. These trades likely accompany existing positions that reflect the Fed’s current message, allowing some traders to benefit from a surprise policy shift.

A deal positioned for a 3% rate by the middle of next year versus the current market level of around 5%. The prize paid for that bet exceeded $10 million. Other similar operations around March were also carried out during the week.

Raising bets that the Fed could pivot to rate cuts by mid-2024, or even sooner, stands in stark contrast to policymakers emphasizing a longer-term bullish narrative. Meanwhile, the Fed’s current rate of 5.25%-5.5%, well above the US annual inflation rate and three-month annualized figure, is seen as a threat to the growth outlook .

Read more: The bond market has never raised recession warnings for this long

As a result, investors are more worried about the recession than they were nine months ago, according to Invesco’s Robert Waldner.

“There is a growing risk of recession as rates remain high and nominal growth declines,” the chief strategist said. “As inflation is falling, central bank policy is becoming more restrictive, and if they don’t consider this, the risk of a crash will increase.”

Positioning through options for next year’s Fed meetings in March and June could make sense, as the bond market risks getting stuck in a holding pattern as investors await clarity on the economy.

According to Vanguard’s Hallam, it is very reasonable to see lower yields in an economic environment heading towards recession. But the picture for bond buyers becomes more complicated if rising energy prices block recent disinflationary trends.

“Sticky inflation would make it very difficult for the Fed to ease monetary policy next year,” he said.

Given the uncertainty over the economic and rate outlook, parking funds in cash equivalents is gaining favor. According to EPFR fund data for this year, short-dated Treasuries yielding above 5% have seen a significant chunk of investment flows lock into relatively high yields.

For Monica Defend, director of the Amundi Institute, the central part of the Treasury bond curve seems attractive for a multi-strategy portfolio.

With rates staying higher for longer, yields should fall as the economy weakens, and sectors with maturities of five to 10 years “are a good alternative to stocks,” he said.

What Bloomberg’s economics says…

A Fed cautious about keeping US rates stable, but keeping options open. “If the labor market cools over the rest of the year as we expect, and the unemployment rate rises to 4.1% as forecast by the Summary of Economic Projections, the Fed is likely to raise rates.”

—Anna Wong, chief US economist

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What to watch

  • Economic data calendar

    • September 18: Service business in New York; NAHB Housing Market Index; ICT flows

    • September 19: Building permits; accommodation begins

    • September 20: MBA Mortgage Applications

    • September 21st: current account balance; initial unemployment claims; Philadelphia Fed Economic Outlook; Sales of existing homes; main index

    • September 22: S&P Global US Manufacturing, Services and Composite PMIs

  • Federal Reserve Calendar

    • September 20: Federal Open Market Committee policy statement and summary of economic projections; Press conference by Fed Chairman Jerome Powell

    • September 22: Mary Daly, president of the San Francisco Fed; Fed Governor Lisa Cook

  • Auction calendar:

    • September 18: 13 and 26 week bills

    • September 19: 42-day cash management invoices; Twenty-year bond reopening

    • September 20: 17 week bills

    • September 21: 4 and 8 week bills; 10-year Treasury inflation-protected securities

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