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The Fed Clears Bond Traders’ Lofty Dovish Hurdle

The Fed Clears Bond Traders’ Lofty Dovish Hurdle

(Bloomberg Opinion) -- Bond traders had set a towering bar for the Federal Reserve to surprise them and ignite a rally. Chairman Jerome Powell and his fellow central bankers had no problem clearing it on Wednesday.

The median projection of Fed officials dropped to zero interest-rate increases in 2019, compared with two hikes in their December forecasts. Historical precedent set a high hurdle for that sort of rapid Fed adjustment. Since the dot plot began in 2012, only in March 2015 and March 2016 did policy makers drop their median “dot” for the same calendar year by 50 basis points (or two full moves) relative to the previous quarter’s meeting. In both previous cases, exogenous shocks prompted the reversal. By contrast, the S&P 500 Index this week reached its highest intraday level since October, while crude oil climbed above $60 a barrel on Wednesday for the first time since November. For the most part, all is well.

The Fed Clears Bond Traders’ Lofty Dovish Hurdle

Consider the following three key economic data points:

  • The U.S. unemployment rate remains close to the lowest level since 1969.
  • Average hourly earnings just increased year-over-year by the most since the recession ended a decade ago.
  • Most broad measures of inflation are close to the central bank’s 2 percent target.

Sure, there are signs of fading global growth, but that shouldn’t be enough for Powell and others to give up the option to raise interest rates later this year if conditions improve.

A move to zero effectively signals this might be the end of the cycle. It raises questions about what the Fed is seeing in the economy to justify that stance. It cut its 2019 gross domestic product forecast to 2.1 percent from 2.3 percent — a downgrade, yes, but not a sharp one. Powell even said he expects the economy to grow at a solid pace and noted that inflation remains near the central bank’s goal. 

Meanwhile, the Fed also overshot the consensus on when it would end its balance-sheet normalization. The central bank will taper the runoff and expects to halt it in September. Treasuries rallied, with the benchmark 10-year yield falling eight basis points to 2.53 percent, the lowest since January 2018 and approaching the upper bound of the fed funds rate. Two-year yields tumbled seven basis points to 2.4 percent. The yield spread between three-month bills and 10-year Treasuries fell as low as 6.1 basis points, the lowest since August 2007. That part of the curve has inverted before each of the past seven recessions.

Interestingly, Nomura Securities strategist George Goncalves surveyed more than 200 investors in the lead-up to the meeting and asked whether they expected the Fed’s next move to be raising or lowering rates. He found that even equity investors, with the S&P 500 up almost 13 percent this year, thought the central bank wasn’t quite done with tightening. “We see some bias depending on respondent asset class, with fixed-income respondents leaning more towards rate cuts while all other groups tilt towards the Fed resuming hiking.”

It seemed as if bond traders got ahead of themselves on this one. Instead, a full interest-rate cut is almost priced into fed fund futures by mid-2020, up from year-end 2020.

“They’re overreacting,” Scott Minerd, chief investment officer at Guggenheim Partners, said in an interview on Bloomberg TV. “The market’s starting to price in an ease, and I really don’t think the environment justifies that.”

“They basically have returned the punch bowl and are encouraging everybody to have a drink,” he said. “Ultimately, there is a day of reckoning.”

It’s one thing for the Fed to say it’s being patient before raising interest rates again. This latest decision all but says it’s done tightening. Policy makers had every opportunity on Wednesday to keep the option open for another rate hike this year. The fact that they gave that up tells traders all they need to know.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

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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