Bond Traders' March Fed Guide: Beware the Four-Hike Hype So Soon

(Bloomberg) -- For a Federal Reserve meeting at which an interest-rate hike is virtually guaranteed, the decision still holds plenty of market-moving potential for bond traders.

That’s because new Federal Reserve Chairman Jerome Powell gave markets the impression last month that he’s open to tightening four times in 2018, rather than the three currently reflected in policy makers’ “dot plot” projections. Officials will update those forecasts this week, and Powell will hold a press conference, after his February signals encouraged a fresh round of U.S. yield-curve flattening.

Some Wall Street banks (notably Goldman Sachs Group Inc.) expect the median projection of 2018 hikes to climb to four at this meeting. Others doubt that central bankers, who’ve reiterated their intention to move gradually, would ramp up expectations so quickly, especially after a round of mediocre data reduced estimates of economic growth. At stake for traders is whether the rout in shorter-maturity Treasuries will continue, or if yields will plateau for now.

“Trying to guide the market to more hikes at the March meeting seems a little premature given the fundamental perspective in growth and inflation,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale.

Whatever policy makers decide, it will reverberate across the fixed-income universe and potentially roil markets more broadly. The meeting comes as two-year yields are the highest in almost a decade, while long-end rates have receded from their 2018 highs. The yield curve is close to the flattest since 2007 and an accelerated pace of hikes could push it closer to inversion.

Here are a few scenarios for traders to ponder and the likely market reaction:

Goldman’s Right

Traders and strategists generally agree that the most hawkish scenario would cause the yield curve to flatten even further, to post-recession lows. SocGen’s Rajappa and Jim Vogel at FTN Financial Capital Markets say the two-year yield would probably rise to about 2.35 percent, from 2.29 percent Friday.

To be clear, Goldman isn’t a complete outlier. BNP Paribas has joined the camp predicting an increase in the 2018 dots. John Herrmann at MUFG Securities Americas says he sees a 60 percent chance of the median dot rising to four this meeting.

“With all of the volatility in the markets right now, I can see the logic of waiting to raise to a median of four hikes at the June meeting,” Herrmann said.

The prospect the Fed will hold off leads to the next potential outcome.

Happy Medium: Mean Dot Rises, 2019 or 2020 in Focus

Analysts at Morgan Stanley and Bank of America Corp. warn that investors expecting a higher 2018 median dot are set for disappointment, given Powell and a few other officials would all have to move in tandem. Yet upward revisions could still be enough to boost the mean forecast.

“Powell is going to soften us up and let us get ready for the idea that maybe there’s going to be more than three rate increases,” Scott Minerd, chief investment officer at Guggenheim Partners, said in a Bloomberg TV interview. “The Fed is going to be very sensitive to market turmoil.”

Officials could increase their projections for 2019 and 2020 rather than shock traders by boosting this year’s outlook.

In that scenario, “the entire curve could get hit to some degree,” though shorter maturities would underperform, said Michael Lorizio, a senior trader at Manulife Asset Management.

Others aren’t so sure. Rajappa at SocGen views longer maturities as more vulnerable in that outcome, with the curve from 2 to 10 years potentially steepening by about 10 basis points.

Read a summary of Wall Street research on potential dot plot changes.

Hold Steady: Let Economic Uncertainty Play Out

Powell was optimistic about the economy in late February, saying his outlook had strengthened and the latest data added to his confidence about inflation quickening. At the time of his second round of Congressional testimony, the Atlanta Fed’s GDPNow model estimated first quarter growth at 3.5 percent.

After a flurry of data misses, the gauge now stands at just 1.8 percent. Granted, it’s a volatile measure. But the trajectory, seen with the New York Fed’s GDP model as well, could head off any moves in the dot plot and prompt Powell to change his tone at his press conference.

“If I was sitting on the Fed board, I would certainly be saying let’s wait a while before we get overly hawkish,” said Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings. While officials still probably want to raise rates four times this year, “the rhetoric might be a little more dovish than what was expected two to four weeks ago.”

Because the markets are well-priced for the Fed’s current path, yields probably wouldn’t adjust much from prevailing levels.

But that would do little to cool the curve-flattening fervor that’s staged a comeback in the past few weeks.

What Else to Watch This Week

• G-20 finance ministers and central bankers meet in Buenos Aires on March 19 and 20; topics of discussion likely to range from trade to inflation to crypto currencies
• Quiet start to the week for U.S. economic indicators ahead of the March 21 FOMC decision
  • March 21: MBA mortgage applications; current account balance; existing home sales
  • March 22: Jobless claims; FHFA house price index; Bloomberg economic expectations and consumer comfort; Markit U.S. manufacturing, services and composite PMIs; leading index; Kansas City Fed manufacturing activity
  • March 23: Durable and capital goods orders; new home sales
• A few Fed speakers scheduled around the rate decision
  • March 19: Atlanta Fed’s Raphael Bostic speaks on Community Reinvestment Act
  • March 23: Bostic speaks on the economic outlook; Minneapolis Fed’s Neel Kashkari speaks in moderated Q&A; Boston Fed’s Eric Rosengren speaks at international research forum; Dallas Fed’s Robert Kaplan speaks in Austin
• In addition to short-term bill sales, Treasury will auction $11 billion of 10-year inflation-linked debt on March 22

--With assistance from Vivien Lou Chen

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, Vivien Lou Chen

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