Powell Inherits a Fed That's Slowly Earning Bond Traders' Trust

(Bloomberg) -- When it comes to winning over traders in the $14.2 trillion Treasuries market, Jerome Powell has it relatively easy.

Donald Trump’s choice to lead the Federal Reserve would take the helm after a year in which the central bank’s credibility has shot up in the bond market’s eyes. Under the guidance of Janet Yellen, policy makers have stayed true to their forecasts for gradual tightening in 2017, and traders are bracing for more of the same. The third rate increase that policy makers predicted for this year looks set to take place next month and the market is starting to price in a greater chance of another hike in March.

Traders still have plenty of catching up to do: They still only see about 2.4 additional rate increases between now and the end of 2018, compared with policy makers’ projection of four. The market has underestimated the resolve of Fed officials all year, only to come around as announcement dates approached. Strategists expect that pattern will persist in coming months, unless inflation heats up. Then investors would rush to fall in line with the central bank’s forecasts.

“The Fed has delivered this year, and next year, based on our forecasts, inflation is going to start picking back up,” said John Briggs, head of U.S. rates strategy at NatWest Markets. “The risks are for the front end of the market, that expectations will move back up toward the Fed.”

The bond market and the Fed seemed to be in a tug of war as Yellen sought to start normalizing monetary policy during her tenure, with the central bank reluctant to move without preparing traders. Last year, traders were well served by maintaining a skeptical view of Fed projections: Policy makers anticipated tightening four times in 2016, then moved just once.

That dynamic shifted in 2017, with concerted commentary from officials jolting market odds higher just before their March rate increase. Three weeks before the decision, not one of the Fed’s primary dealers was firmly forecasting a hike.

New Dynamic

Times have changed. Markets are pricing in more than an 80 percent chance of a quarter-point hike on Dec. 13, showing confidence officials will hit their projection for three increases this year. And bets on the following hike coming in March are gaining traction. The probability of that timing is about 30 percent in the swaps market, up from 25 percent two weeks ago, before a report that Trump was leaning toward Powell.

“The market was always far away from the Fed during the Yellen years,” said Kathy Jones, chief fixed-income strategist at Charles Schwab & Co. “Now that we’re actually in a rate-hiking cycle and the economic numbers both domestically and globally are improving, the market may be underestimating what the Fed ends up doing next year.”

The two-year Treasury yield is near the highest since 2008, while the five-year rate is 2 percent, a level that until a year ago hadn’t been seen since 2011. The maturities are among the most sensitive to Fed policy expectations.

In contrast, 10- and 30-year yields have declined in 2017 as inflation indicators have held below the Fed’s 2 percent target.

“It’s truly just the low inflation numbers that are holding things where they are,” said Stephen Stanley, chief economist at Amherst Pierpont Securities. “If we were to see two or three firm core inflation numbers in a row, that would be what would really change the market thought process.”

Figuring out inflation, which Yellen has called a “mystery,” will soon become Powell’s problem, assuming he wins Senate confirmation. But as for dealing with the bond market, this year’s Fed provided the roadmap.

--With assistance from Liz Capo McCormick and Edward Bolingbroke

To contact the reporter on this story: Brian Chappatta in New York at bchappatta1@bloomberg.net.

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Mark Tannenbaum

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