Expect a Market Brawl If Fed Doesn't Show It's Ready to Act
It would be tough for the Fed to surpass the market’s expectations, but a rate cut might.
(Bloomberg) -- Rates traders should prepare for turbulence around this week’s Federal Reserve decision: Markets aren’t giving up on rate cuts without a fight.
Avoiding a volatile session Wednesday could require some fancy policy-making footwork. There’s a widespread desire for proof the Fed is ready to act, but too much change could raise alarm. Central bankers can adjust their message in a variety of ways, but none of them are likely to produce significantly higher yields, according to investors including Loomis Sayles & Co.’s Elaine Stokes.
The market’s doves have the Fed cornered. If it sticks to its May pledge to be “patient” as it judges future rate moves and keeps the door open to a hike next year, riskier assets like stocks will probably slide and yields will sink further as traders rush to havens.
“The market riots on that,” said Stokes, a fixed-income portfolio manager.
Instead, the Fed is expected to take another dovish turn, just as it’s done all year as weak inflation, deteriorating growth and U.S. trade policy uncertainty sent Treasury yields tumbling. But the Fed hasn’t caught up with rate-cut expectations and probably won’t now, with positioning as aggressive as ever. Anxiety over the Group-of-20 meeting this month has mired the yield on two-year notes around 1.85% -- down from almost 3% in November -- and spurred bets that the Fed policy rate will drop 65 basis points by year-end.
Here’s what to look for in the Fed’s statements and press conference Wednesday and some potential scenarios for reactions in the $16 trillion Treasuries market.
Delicate Balance
Investors are anticipating some combination of the following to demonstrate the Fed’s readiness to cut:
- Dropped reference to policy patience and inflation being dragged down by transient factors
- Emphasis on weak inflation and growth risks from trade hostilities
- Ending the balance-sheet unwind sooner than September
- Downward revisions of the rate-projection dot plot
The right balance of these could nudge yields a bit higher, as traders exit some rate-cut hedges. Amherst Pierpont Securities LLC’s head of Treasury trading, Paul Murphy, expects weakening in the two-year note and related futures contracts. But if the Fed convinces investors it’s ready to cut rates, wagers for a move in the third quarter won’t go away.
“The market could have a little bit of a relief sell-off and little bit of a repricing, but that would be somewhat innocuous,” Murphy said.
Don’t expect much action further out the curve, either. T. Rowe Price fixed-income portfolio manager Chris Brown said if markets are comfortable with the Fed’s messaging -- and even if the G-20 summit stirs optimism on the trade front -- the 10-year yield probably can’t get much higher before buyers step in. The past month’s rallies have carved out a range for the 10-year between 2% and 2.40%, he said.
Release the Doves
It would be tough for the Fed to surpass the market’s expectations, but a rate cut might. As of Monday, pricing reflected only a 16% chance of a 25-basis point reduction at this week’s meeting.
Rewarding these bets would not clear them out, however, according to Loomis’s Stokes. By over-delivering, policy makers would only raise the suspicion that they’re responding to a bigger, undisclosed threat. Futures contracts beyond this year would gain on the prospect of more easing to come, if traders reason that “this doesn’t feel like insurance, this feels like a Fed cycle,” she said.
“If there are expectations that this is the beginning of a more drawn-out easing cycle, the impact on the curve is the most important to look at,” with a more pronounced steepening the most likely outcome, said Amherst Pierpont’s Murphy.
‘Double Jeopardy’
If the Fed doesn’t bend closer to the market’s vision, T. Rowe’s Brown expects a tantrum in three stages. Higher yields is the first and the most fleeting.
“If the Fed comes off as hawkish I think you’ll see a knee-jerk selloff at the front end,” Brown said. That would quickly give way to a bullish move as a meltdown in risk assets drives buying in long-dated Treasuries, in a second wave of curve flattening. The delayed reaction is for the curve to re-steepen, he said, as investors move back into short-dated Treasuries on the conviction that the Fed will have to take emergency action later.
To Murphy of Amherst Pierpont, this is the “double-jeopardy” scenario whereby stock-market volatility exacerbates the recent tightening in financial conditions due to trade policy uncertainty. “Then the market’s really going to force them to do something later in the year,” he said.
To contact the reporter on this story: Emily Barrett in New York at ebarrett25@bloomberg.net
To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Nick Baker, Mark Tannenbaum
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