(Bloomberg) — Bond investors battered by the sharpest volatility in decades are focusing on their next big challenge: navigating the Federal Reserve’s response to the turmoil Increasing financial stability threatens to derail the agency’s fight against inflation.
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Regardless of what the central bank does, investors face more losses after volatility surged to levels not seen since the 2008 financial crisis. Treasuries and the abrupt revision of Fed rate bets are signaling another 25 basis point rally as the most likely scenario at this stage. Now, what really worries Wall Street is what officials will do next.
Traders now see the central bank’s benchmark ending the year around 3.8%, one percentage point below the Fed rate estimate in the December “dot chart,” part of the forecast. quarterly economy. That is a possible dovish scenario on Wednesday as the new forecasts come out.
Inflation remains high and the labor market has shown resilience despite the most aggressive tightening campaign in decades. Whether the Fed chooses to stay focused on that or prioritize concerns about the health of the financial system could determine the path forward for rate hikes.
“Risk is two-way at the moment, and possibly even more so,” said David Robin, a veteran interest rate market strategist at TJM Institutional in New York. “The only move by the Fed that is definitely undisputed is a 50 basis point increase. On the other hand, there are more policy probabilities and even more response function probabilities. It will feel like an eternity until next Wednesday at 2pm.”
Amid anxiety, the widely watched MOVE index, an options-based measure of the expected volatility of Treasury bonds, hit 199 points on Wednesday, nearly doubling since late January. Yields on US two-year bonds, typically a low-risk investment, have ranged between 3.71% and 4.53% this week, the widest weekly range since September 2019. 2008.
The Federal Open Market Committee will raise interest rates by a quarter point at its March 21-22 meeting from the current 4.5%-4.75%, according to economists surveyed by Bloomberg News. Fed Chairman Jerome Powell raised the possibility of a return to larger moves, meaning half a point or more, if warranted by economic data. But that was before concerns about the banking system sent the markets reeling.
Even with turmoil engulfing Credit Suisse Group AG and several US regional lenders, the European Central Bank continued with its plan to raise half a point on Thursday – but offered little clues as to what could be happening.
Now the issue is whether recent banking woes limit the Fed’s ability to tackle the upside, which, while moderate, is still well above the 2% target.
“The most painful outcome would be a Fed stepping in and saying we have a financial stability problem and it’s being worked out,” said Ed Al-Hussainy, interest rate strategist at Columbia Threadneedle Investments. . Then the Fed will be able to stick with the fight to contain inflation and keep tightening, he said. “It is an outcome that the market is not prepared for this period.”
That raises the question of whether the move to lower market prices has now gone too far.
Points
Back in December, U.S. officials forecast they would raise interest rates at a slow pace, with the median predicting a benchmark of 5.1% by the end of 2023. Following Powell’s remarks to analysts US legislator on March 7, bets for the new dot chart suggest further tightening – with swap traders pushing expectations for the top rate to around 5.7%.
Those bets quickly fizzled out amid fears of a widespread banking crisis that could trigger a credit crunch at a time when bets on recession are rampant. . Now, swap traders are betting that Fed policy tightening will peak around 4.8% in May, with interest rates falling through the end of 2023.
Any hawkish surprise from the Fed’s dot plot will deal a blow to investors — especially after this month’s sharp rally in Treasuries.
For Anna Dreyer, Total Return Fund’s co-portfolio manager at T. Rowe Price, the only certainty amid all the uncertainties is the “tuck war” between the bank’s contagion and inflation concerns. That is what will continue to drive sentiment in the interest rate market.
“What we don’t know is how tight they are and what impact they will have on growth and the US economy,” said Ashish Shah, chief investment officer of public investment at Goldman Sachs Asset Management. . “Banks will set a higher lending threshold and that will have the effect of slowing growth. The conclusion for investors is that they should price rates with more uncertainty in both directions.”
What to see
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Economic data calendar
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March 21: Philadelphia Fed Manufacturing Index; Existing home sales
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March 22: MBA Mortgage Application
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March 23: Claims for unemployment; current account balance; Chicago Fed’s national activity index; new home sale; Kansas City Fed Manufacturing Index
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March 24: Durable goods orders; material production orders; S&P Global US manufacturing and services PMI; Kansas City Fed Service Operations
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Federal Reserve Calendar
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Auction schedule:
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March 20: terms of 13 and 26 weeks
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March 21: 52-week bill; 20 year bond
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March 22: 17 week bill
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March 23: terms of 4 and 8 weeks; 10-year Treasury inflation-protected securities
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