Bond Traders Hear What They Want to Hear in Fedspeak
(Bloomberg Opinion) -- Just when it seemed as if traders in the world’s biggest bond market had finally gotten over reading too much into every word uttered by Federal Reserve officials, they reverted to their bad habits on Friday.
Two-year Treasury yields fell for the fifth consecutive session, the longest streak since November 2016, to the lowest level in three weeks. The spread between five- and 30-year maturities soared to the highest since March as the short end led the rally. All this, seemingly, because of a few words from a couple of policy makers. Fed Vice Chairman Richard Clarida said that the central bank has to factor in the global growth outlook and that there’s “some evidence that it’s slowing.” Dallas Fed President Robert Kaplan said he sees “a little bit of latitude to be patient and gradual.”
This doesn’t strike me as new information. Of course the Fed has to consider how its policies affect the global economy because we live in an interconnected world and any adverse shocks could harm the U.S. outlook. What that doesn’t mean, however, is that the central bank is destined to pause if there’s a hiccup overseas while America is still humming along. It’s no surprise to anyone that the Fed is getting closer to its ill-defined “neutral” rate, but whether it’s 25 or 125 basis points away is anyone’s guess — including policy makers themselves. Again, the market knows this, and that’s effectively what Kaplan means when he says they can take their time.
So how to explain the swift reaction in the $15.4 trillion Treasury market? I chalk it up to confirmation bias. As Bloomberg News’s Edward Bolingbroke pointed out, even before Clarida and Kaplan spoke, short-end interest-rate traders were losing confidence that Fed officials could pull off two rate increases next year, let alone the three that they now project. Expectations for 2019 are now the lowest in two months, with traders effectively pricing in fewer than 1.5 moves.
Unless you have very high conviction that the U.S. economy is going to tank next year, that sort of pricing looks off base. Fed Chairman Jerome Powell has demonstrated time and again that he’s not going to be deterred by fluctuations in the equity markets, nor by disturbances around the globe like those in Turkey and Argentina. The unemployment rate is the lowest in a half-century and inflation is close enough to 2 percent that he and other officials will want to stay the course of gradual and consistent tightening until something clearly persuades them to stop.
That “something” is what traders should be truly focused on, not interpreting Fedspeak. Next week brings some important economic data before the U.S. Thanksgiving holiday, like housing starts, durable and capital goods orders and existing home sales. More comes the following week, including the latest reading of the central bank’s preferred inflation gauge. If those reports signal unexpected weakness, then they can start pricing out the Fed next year.
For now, though, Citigroup Inc.’s economic surprise index is the highest since July. Next year will bring press conferences after all eight Fed meetings, meaning each one is truly “live” and policy makers have more flexibility to raise rates when they have an opportune window. Maybe the market will ultimately be proved correct in the rapid repricing over the past week. But count out the Fed at your own risk.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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