Bond Market Dares Fed to Defy It After Bloody Week for Investors
(Bloomberg) -- Bond traders are looking to the Federal Reserve to support the hawkish shift that just drove parts of the global bond market to one of its wildest weeks in decades.
In a span of a few days, the view that some major central banks will be slow to raise rates shattered into pieces. Short-term yields from Canada to Australia jumped the most since the 1990s, catching even some of the best money managers flat footed, as policy makers shifted gears to move more firmly against inflation once seen as likely to be transitory. At the same time, long-term rates slid -- a signal that aggressive policy moves are likely to slow the pace of economic growth.
The capitulation of some central banks has emboldened U.S. traders, who are betting the Fed will start backing away from its mantra that the acceleration in consumer-price gains would be a short-lived side effect of the Covid pandemic. And as traders shift their attention away from officials in Ottawa and Sydney and more acutely back toward those in Washington DC, they’re now pricing in an almost 90% of chance that the Fed will make its first quarter-point hike in June.
“The markets are certainly testing the limits of central banks,” Wells Fargo Asset Management’s George Bory said on Bloomberg Television.
The Fed is widely expected to announce on Wednesday that officials will start scaling back their $120 billion-a-month bond-buying program, which has helped to hold down rates since the early days of the pandemic. While Chairman Jerome Powell has emphasized that step is not mechanically linked to the timing of rate hikes, traders could look to draw conclusions about when benchmark increases might begin, especially given that the central bank might not want the two processes to overlap. Powell has talked about wrapping up tapering by mid-2022, but a faster-than-expected pace could bring forward the window for hikes. It would also likely signal greater concerns about inflation, which has the potential to inject further volatility.
With labor shortages fueling a record increase in wage-and-benefit costs, the swaps market on Friday was pricing in around 22 basis points of tightening for the June meeting. That indicates that -- in traders’ minds at least -- the central bank is almost certain to implement a standard 25-basis-point increase then. Just a week ago, the market was pricing 16 basis points, suggesting a less than two thirds probability of such a boost.
Looking a little further out, swaps are pricing in more than two full quarter-point hikes in 2022, compared with one or none predicted by a majority of officials in the so-called dot plot release from September.
“It seems like the Fed is trying to avoid even being tempted to surprise markets by locking in a tapering schedule that delays rate hikes until the second half of next year,” Tim Duy, a long-time Fed watcher and chief U.S. economist at SGH Macro Advisors, wrote on Oct. 27. “The risk here is that the longer the Fed resists signaling future hikes more aggressively, the more disruptive the market reaction will be when that signaling happens.”
Investors just got a taste of what it looks like when central banks suddenly change course. Yields on Australia’s benchmark three-year bonds posted the biggest monthly increase since 1994 after the Reserve Bank of Australia gave up on defending its yield target. In Canada, the central bank on Wednesday surprised markets by ending its bond-buying program and accelerated the potential timing of future interest rate increases, causing the gap between 2- and 10-year bond yields to narrow the most in almost two decades. In Europe, investors have pushed forward the expectations for rate hikes next year even after European Central Bank President Christine Lagarde said such a move is inconsistent with the bank’s guidance.
The swings also spilled over to the U.S., where the difference between two- to 10-year Treasury yields flattened by 13 basis points Wednesday. Cornerstone Macro estimates that was among the biggest one-day moves in the yield curve since 2000.
Such moves have caught some veteran fund managers off guard. Chris Rokos’s hedge fund has sunk 11% in October, hurt by an ill-timed bet on the U.K. and U.S. yield curve.
“This is the closest we can get to a distressed market,” Deutsche Bank AG’s global head of FX research George Saravelos, wrote in a Oct. 28 note titled “It’s a VaR shock now.” The value-at-risk shock refers to a surge in an investment loss that prompts positions to be liquidated.
There no shortage of investors and strategists who say the moves were excessive and overly discount the risk that growth will slow next year. And, historically the Fed has tended to lead other central banks in monetary-policy changes, not follow. Marko Kolanovic, a widely-followed strategist at JPMorgan Chase & Co., recommended his clients position for yields to resume moving higher for that reason.
“The market has gotten a little bit ahead of itself,” said Peter Tchir, head of macro strategy at Academy Securities. “The Fed will try to aggressively talk the market back next week.”
Either way, a lot is at stake, for both investors and the Fed next week.
“At this point, you either think the Fed blinks or they don’t,” said Neil Dutta, head of economics at Renaissance Macro Research. “The question is do they want to validate what’s in the market or not. The question is how does the Fed build its credibility by keeping on doing what you say or changing as conditions evolve? There are a lot of open questions.”
What to Watch
- The two-day Federal Open Market Committee meeting that ends Wednesday is set to be the major focus for traders, along with the Treasury Department’s quarterly refunding announcement earlier the same day, while official monthly payroll data Friday will also be important
- The economic calendar:
- Nov. 1: Institute for Supply Management and Markit manufacturing purchasing manager indexes; construction spending
- Nov. 2: Vehicle sales
- Nov. 3: MBA mortgage applications; ADP employment report; ISM and Markit services PMIs; factory, durable goods and capital goods orders
- Nov. 4: Challenger job cuts; weekly jobless claims; Langer consumer comfort gauge
- Nov. 5: Monthly jobs report; consumer credit
- Fed officials:
- Nov. 3: Powell speaks at press conference following FOMC decision
- The auction calendar:
- Nov. 1: 3-month, 6-month bills
- Nov. 2: 52-week bills
- Nov. 3: Treasury’s quarterly refunding announcement
- Nov. 4: 4-week, 8-week bills
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