A runner passes the Marriner S. Eccles Federal Reserve building in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

Traders Redouble Dovish Bets Even as Case for Fed Cut Dwindles

(Bloomberg) -- A brighter economic outlook has infused rates and currency markets in the past few weeks, but for some that’s only presented an opportunity to prepare for the worst.

Bets on a drop in short-term rates are picking up, possibly reinvigorated by speculation that the Federal Reserve is contemplating a preemptive rate cut to coax inflation closer to the central bank’s goal. Traders are focusing on eurodollar options contracts for late 2019 and 2020, and Wednesday also brought a wave of buying of five-year Treasury futures.

“There is still this underlying sense of eternal pessimism in the market,” said Thomas Simons, senior money markets economist at Jefferies LLC. “Any time there’s even a sniff of a recession sign, it’s latched onto as the base-case scenario.”

Expectations for policy easing may seem incongruous given indications of a rebound in the world’s largest economies. In the U.S., the latest jobs report confirmed one of the strongest labor markets in 50 years. Manufacturing and retail sales have improved in both the U.S. and China, where fiscal and monetary stimulus are taking effect. That may stir a recovery in Europe, where a disappointing German confidence survey Wednesday provided another excuse for haven buying.

The missing link is inflation. The Wall Street Journal reported this week that the Fed may be considering a “fine-tuning” rate cut to help meet its 2 percent inflation target. The Fed’s favored measure is languishing at just 1.4 percent.

The latest dovish market positioning may owe less to a conviction that cuts are coming, than the cheapness of taking out insurance, Simons said.

“I’m sure that between now and December something else is going to happen that will switch the general consciousness to think that the economy is taking a turn for the worse again, and those bets are going to look better then,” he said.

Wednesday’s rate-market trades helped restore some of the more-aggressive pricing for a cut that was in place throughout the first quarter. That positioning persisted after the March meeting -- when the median projection of policy makers fell from two hikes this year to none -- but had eased up on more-positive April data releases. As of Wednesday, rate markets are pricing almost a full quarter-point cut by the end of this year.

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