The Fortune of Bond Traders Depends on Where the Fed Rate Comes to Rest

The Fortune of Bond Traders Depends on Where the Fed Rate Comes to Rest

(Bloomberg) — The fate of many big bets in the U.S. bond market hinges not only on the size of the Federal Reserve’s next rate hike on Wednesday, but perhaps even more on its revised forecasts for where the policy rate will eventually come. rest and how long it is likely to remain at that level.

Read more from Bloomberg

Over the past week, implied expectations from the market were higher after the latest monthly inflation data was less modest than expected. Swap contracts predict rates over the next two years will now peak at 4.5% in March 2023, a whole point higher than expected after the Fed’s last meeting in July. Meanwhile, the latest year-end forecasts from Fed policymakers – the so-called dot plot, formed in June – are almost below 4% for 2022-2024.

The change involved a batch of wagers – with millions at stake – that the peak will be around 5%, if not higher. Others are betting on an end-2023 rate of around 4.5%, but the wider market expects a decline to around 4% by then. While next week’s policy decision could move markets if it exceeds the three-quarter point increase most expected, the revised dot plot and Fed Chairman Jerome Powell’s vision for the future will be more important to some of the promised that.

“The September FOMC policy action is certainly important, but it’s a little bit like not seeing the forest for the trees,” said Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, which manages about $17 billion in assets. . “From our perspective, as investors who really focus on the next 6 to 12 to 18 months, it’s less about one meeting and more about the cumulative” the Fed rate moves. “We expect Powell to deliver another hawkish message as well.”

As a result of the August inflation data released on September 13, the market managed to fully price in a third consecutive three-quarter point rate increase on September 21 — giving the target range for the federal funds rate to 3%-3.25% — and assign non-zero odds to a full-point hike. The US central bank has raised rates four times since March in response to accelerating inflation. The rate increases follow a two-year period when the lower limit was 0%.

At the same time, resilience in employment prompted revisions to next year’s forecasts. JPMorgan Chase & Co economist Michael Feroli now expects a half point hike in November, up from a quarter point, and a quarter point move in December and February, taking the terminal rate to 4.25%. And if the labor market hasn’t shown clear signs of cooling by then, “then we want the Committee to continue tightening with 25bp moves until that happens.” Bloomberg Economics chief economist Anna Wong predicts the terminal rate will be 5%.

As of June, the median projections for fed funds are 3.4% at the end of the year, 3.8% a year later and 3.4% at the end of 2024. Economists at Citigroup Inc. predicting that the medians will rise to around 4.25% for 2022 and 4.5% for 2023. Strategists at BMO Capital Markets predict that the updated points point to the terminal rate in the 4.25%-4.5% area.

David Robin, a strategist at TJM Institutional, who has worked in debt derivatives for many years, said the new dots could indicate a continued upward trend in rates versus a decline in 2024.

Significant trades in debt derivatives this week appear to be anticipating a peak Fed rate in the 4.75% to 5.25% range — levels last seen in 2007. Among the largest is the SOFR options hedging structure based on the policy rate that ends next year at 4.5%.

Read more: Options Traders Accumulate Hawkish Wagers Eye Feed 5% Peak Rate

In the Treasury bond market, sentiment around the Fed has driven two- to five-year yields to their highest levels since 2007, while longer-maturity yields have been largely constrained by expectations that Fed policy will risk the economy. Two- and five-year yields exceeded the 30-year yield this week by the most since 2000.

“The shorts are in charge, and the two-year led market will continue the magnetic pull of a higher terminal rate,” said George Goncalves, head of macro strategy at MUFG. “The focus right now is — through the dots — how far can the Fed push this? The only viable outlet for the Fed is tighter financial conditions, and this is a meeting where they should be pleased that the market is pricing in a more aggressive policy path.”

What to Watch for:

  • Economic calendar:

    • 19 September: NAHB housing market index

    • September 20: Housing begins

    • September 21: MBA mortgage applications; existing home sales

    • September 22: Weekly jobless claims; current account balance

    • September 23: S&P Global US manufacturing, services and composite PMIs

  • Nutritional calendar:

  • Auction calendar:

Read more from Bloomberg Businessweek

©2022 Bloomberg LP

Leave a Reply

Your email address will not be published.