Bond Investors Are at a Crossroads With Fed Pause In Sight

(Bloomberg) — The emerging consensus that the Federal Reserve will raise rates just one or two more times has brought a new set of dilemmas for bond investors, who must now decide which parts of the market will fare better. in these circumstances.

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The U.S. Treasury market hit an inflection point on Thursday when a report showed consumer inflation rates fell to their lowest levels in more than a year, and Philadelphia Fed President Patrick Harker 15 minutes later said that he favored another change in the pace of rate hikes. Implied market expectations for the central bank’s February meeting gravitated further towards a quarter-point increase instead of half a point, and for the first time gave little chance of no move at all in March.

Short- and medium-term yields fell sharply, hitting three-month lows, while the 10-year fell below 3.5%, extending a rise from around 3.8% earlier in the year. Much uncertainty remains; earlier this week, two other Fed officials predicted an extended stay above 5% for the overnight Fed benchmark. But investors are finally seeing the threat of higher policy rates as they set positions.

“The market has discounted all the Fed’s language about pushing the terminal rate higher than 5%,” said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investments. Having favored long-dated bonds in recent months, he predicts mid-caps will fare better nearing the end of the hiking cycle. Ultimately, “once the Fed tells us this is the last hike — and March is a good bet around that — then the upside is there for the taking.”

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Bond investors were devastated last year by rising yields after the Fed raised its target range for overnight interest rates by more than four percentage points in response to accelerating inflation.

Accumulating evidence that inflation has peaked allowed the Fed to ease the reins in December with a half-point increase after four straight three-quarter moves. The latest slowdown in the rate of consumer price growth in December – excluding food and energy, the fourth-quarter rate was 3.14%, a 15-month low – sparked a wave of trading.

In swap contracts that refer to Fed meeting dates, the expected peak for the overnight rate fell to 4.9%. Only 29 basis points of growth are estimated for the February 1 decision – indicating that a quarter point is favored over a half point – and less than 50 basis points are estimated through March.

A flurry of bets on short-term interest rate options after the inflation data predicted the imminent end of Fed rate hikes and further declines in market volatility. They included a major one expressing the view that the cycle will stop after February.

“The path of short-term rates is tied to inflation, with a swing factor around that because of how strong or weak the economy is looking,” said Jason Pride, chief investment officer at Private Wealth at Glenmede. “A 5% funds rate is necessary if inflation goes to 6% and 7%, not so when inflation goes back to 3%, and you could see year-on-year total inflation around 3% by mid-year. .”

Beyond the short-term rates market, the new framework spurred bets on additional gains in the Treasury market.

In Treasury futures, Thursday’s rally resulted in large increases in open interest – the number of contracts in which there are positions – particularly for the 10- and 5-year contracts. The increase was equivalent to buying $23 billion of recently issued 10-year notes, about 20% of the amount outstanding.

The 10-year Treasury yield, which peaked last year near 4.34%, is likely to retreat to around 2.5% within six months if the inflation trend continues, Al-Hussainy said.

“Most of the risk premium at the long end of the curve reflects inflation, and if it comes down faster, or even at the current rate, there’s a big runway for the last repricing,” he said.

It could be very soon. A period of consolidation can be expected for the treasury market after its big gains.

“The inflation story is not over yet and there is some complacency in the market that they have the Fed’s playbook right,” said Lindsay Rosner, multisector portfolio manager at PGIM Fixed Income.

Treasury yields were pushed higher last year by shorter maturities like the two-year, which remains the highest-yielding part of the market at about 4.21%. PGIM expects a reversal of this trend, but it may take some time to continue.

“The slope is the right trade for this year, and it really kicks in after the Fed ends the hike,” she said.

What to Watch

Economic calendar:

January 17: Empire Production

January 18: Retail sales; production price index; industrial production; business inventories; NAHB housing market index; mortgage applications; Fed Beige Book; International Treasury Capital Flows

January 19: Accommodation begins; Philadelphia Fed Business Outlook; unemployment claims

January 20: Existing home sales

Fed calendar:

January 17: New York Fed President John Williams

January 18: Atlanta Fed President Raphael Bostic; Philadelphia Fed President Patrick Harker; Dallas Fed President Lorie Logan

January 19: Boston Fed President Susan Collins; Vice President Lael Brainard; Williams

January 20: Harker; Governor Christopher Waller

Auction calendar:

January 17: 13-week, 26-week bills

January 18: 17 weeks’ bills; 20-year bonds

January 19: 4-week, 8-week bills; Inflation-protected 10-year Treasury securities

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