Bond market pushes slack deals when Fed raises

BOND traders are preparing to risk that Fed Chairman Jerome Powell is willing, willing and able to push the US into recession to control the specter of inflation.

Long-term Treasury yields fell in the wake of the Federal Reserve’s decision to proceed with its third consecutive interest rate hike of 75 basis points. The move was accompanied by expectations showing that rates will need to continue rising, and an acknowledgment by the central bank chief that this fight against inflation will involve some pain.

Short-term interest rates for the first half of 2023 have already jumped higher, bringing market policy rate expectations in line with officials’ expectations near 4.6 percent, and suggesting that traders believe in the Fed’s determination to act aggressively until inflation heads strongly lower. While the initial reaction may have been somewhat hawkish, the jolt from the bond and stock markets was that growth would eventually take a hit.

“If they meaningfully exceed 4 percent, there is a strong chance of a recession,” said Andrzej Skiba, head of the US BlueBay fixed income team at RBC Global Asset Management. “The front sell tells you that the point plot was tighter, while the higher back end suggests a slump is inevitable.”

higher probability

Two-year Treasuries fell further on Thursday, sending the yield up 4 basis points to 4.09 percent. The two- and 10-year curve fell to minus 58 basis points, roughly in line with the August low that was the deepest reversal since 1982. The 30-year yield was down two basis points at 3.48 percent.

Recession forecasts are clear based on the pricing of the swaps through the end of next year. Derivatives contracts for the second half of 2023 point to a half-point cut before the end of the year, challenging the Fed’s current forecast that the policy rate in 2023 will finish above 4.5 percent before tapering back to 3.9 percent by the end of 2024.

“Most of the market seems to think the Fed is going to overplay it. I think there is a greater chance that the Fed will move rates higher than what is currently being shown,” said Chris Arens, strategist at Stifel Nicolaus & Co.

A key consideration is how viscous inflation is now proving that monetary policy is transforming into what policymakers consider a constrained territory. While some expect inflation to ease from now on thanks to higher mortgage rates and the impact on the housing sector, the concern is that higher wages and a tight labor market will continue to drive consumer prices higher.

“Another report on viscous inflation is going to put a wrench in action and the market will expect a 5 per cent rise in prices,” said Skiba of BlueBay.

Campaign price

During his press conference, Powell said that “slow growth and a weak labor market” would be the price of the central bank’s campaign to restore price stability. In their latest summary of economic expectations, Federal Reserve officials predicted the unemployment rate would rise to 4.4 percent next year.

Treasury dealers took Powell’s letter seriously. Another major part of the curve shifted after the Fed meeting, with the 10-year bond yield now exceeding the 30-year yield for the first time since June.

Ben Emmons, global macroeconomic analyst at Medley Global Advisors, said there is no escaping the fact that the bond market situation warns of a growing potential for a hard landing.

“Long-term bonds lend credibility to the Fed’s determination to restrain because that guarantees, from a bond market point of view, a painful recession,” he said.

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