Trillions Are in Motion as Traders Eye Paradigm Shift for Rates

(Bloomberg) -- It’s been just four weeks since the first U.S. rate cut in more than a decade, but a mass migration is already underway in financial markets.

The Federal Reserve’s pivot to easier monetary policy has spurred the busiest August for the $4 trillion U.S. market for exchange-traded funds since the government-debt downgrade of August 2011, as everyone from mega-traders to mom-and-pop investors adjusts to a new paradigm.

No wonder, for there’s a lot to take in. Beyond the U.S. central bank’s bold step, there’s an escalating trade war with China, a record-beating stockpile of negative-yielding bonds, and persistent signals of recession lurking within the yield curve. Together, they’re fueling a multi-trillion-dollar rethink of strategies heading into year-end.

“Investors had been anticipating a rate cut, and now that it’s happened, they’re trying to determine if the risk is even greater than they perhaps previously perceived,” said Todd Rosenbluth, director of ETF research at CFRA Research. “Given the strong interest in safe-haven assets and strong trading volume in August, we could see an acceleration.”

Debt Rotation

Almost $2.2 trillion of ETF shares have changed hands this month, typically a sleepy period for markets, data compiled by Bloomberg show.

Nowhere was this more evident than within the bond market, where ETF trading topped its record for the month. Floating-rate notes, which tend to do well when rates rise, are out of fashion, and inflation-protected securities -- which hedge against price gains, a byproduct of lower rates -- are back in vogue.

ETFs focused on floating-rate notes have hemorrhaged a record $1.4 billion since the Fed reduced rates, and outflows could deepen if traders’ bets for further cuts by year-end come to fruition.

“The forecast for the payout on those is not good,” David Donabedian, chief investment officer of CIBC Private Wealth Management, said of these notes. “Certainly a part of that is the realization that rates are going down, not up.”

The Fed meets again in mid-September and futures pricing shows traders see rates declining 50 basis points by Dec. 31, with a 36% chance of an additional quarter-point cut.

Trading patterns suggest that much of the money that’s fled floating-rate notes has gone into ETFs owning inflation-protected securities, which gained a record $1.5 billion this month.

Policy makers viewed their July cut as, in part, insurance against too-low inflation, minutes from the central bank’s meeting show. Price gains have stubbornly remained below the Fed’s 2% target for years, despite strong employment and consumer-spending data, but further rate cuts could turn the tables.

“It’s not surprising,” Candice Bangsund, a portfolio manager at Fiera Capital, which is betting on TIPS, said of the ETF influx. “It ties into that theory that inflation expectations are much too low. There’s very little regard for the fact that inflation is actually moving higher.”

But investors still risk jumping the gun. While traders have boosted expectations for further rate cuts, Fed Chair Jerome Powell described lower rates as a “mid-cycle adjustment” and rejected the idea of a return of looser monetary policy unless the economy weakens drastically.

Meanwhile, the Fed’s preferred measure of inflation showed signs of rebounding in June. Data for July is slated to be released on Friday and at least some investors are betting it could continue its upward trend, mitigating the need for further rate cuts. Floating-rate notes now look cheap to Pacific Investment Management Co., which believes that the market’s expectations for further easing are too high.

Still, with the rotation underway, it could take more than one piece of economic data to roll back the tide of cash that’s on the move.

“What happens when we get these volatile markets like we’ve seen, you see investors moving, you see fund flows moving,” said Chris Gaffney, president of world markets at TIAA, who says investors are being more defensive. “Could they change? Certainly. If we get really good news on the trade front, it could change.”

--With assistance from James Seyffart and Tom Lagerman.

To contact the reporters on this story: Vildana Hajric in New York at vhajric1@bloomberg.net;Emily Barrett in New York at ebarrett25@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Rachel Evans, Rita Nazareth

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