(Bloomberg) – A bond market that wants to rally is eagerly waiting for the Federal Reserve to give it the green light next week as a robust economy continues to reverse bullish positions.
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Treasuries have surged in recent weeks, sending yields on policy-sensitive two-year bonds down nearly 30 basis points from this year’s high of 5.12% hit July 6, as signs of slowing inflation bet policymakers are nearing the end of their most aggressive bull run in decades.
Now, with a quarter-point hike priced into the July 26 decision, the swap market is pricing just a one-in-three chance of a hike later this year, up from more than 50% earlier this month. Meanwhile, fund managers are extending their exposure to longer-dated Treasuries as they expect the central bank to remain on hold – and ease next year – after hitting its highest level since 2001.
As markets position themselves for a slowdown in inflation, this outcome is far from clear. Not only is the labor market holding up, but the housing sector also appears to have absorbed the Fed’s rapid 500 basis point tightening. Moreover, the central bank’s efforts to protect the banking sector have eased financial conditions, suggesting that the Fed’s own estimate of two more rate hikes this year remains very much on the table.
“The market senses the Fed is nearing the end, but if the economic data holds between July and September, the bond market should price in another run,” said Gregory Faranello, head of U.S. rates trading and strategy for AmeriVet Securities. “For Jay Powell, the end game is always about lowering inflation and looser financial conditions run counter to that. There is no reason to believe that the Fed’s stance in June on two more hikes has changed.
Retaining the option to hike again will likely be one of Powell’s main talking points for his press conference. For Brandywine Global Investment Management’s Jack McIntyre, the Fed chief is likely to be dovish.
“It will be interesting to see what matters most to the Fed here. Is this recent data showing some slowing in the economy and inflation, or do they want to retain that hawkish bias,” he said, adding that he suspects “the Fed is moving from a hawkish pause – in June – to a dovish hike” this month.
As things stand, the Federal Open Market Committee is expected to raise the policy rate range to 5.25-5.5% when it meets next week. Beyond that, only nine basis points of increases are valued by the market, illustrating how the market is discounting another increase.
That leaves investors vulnerable to being caught off guard if the labor market holds up and inflation holds steady over the next two months – a trope that dominates this year’s playbook.
Bets on a recession in January were dashed as stronger data pushed yields sharply higher; the two-year Treasury peaked at around 5%. Then the US bank failures in March saw the two-year note fall below 4%. And more recently, as contagion risk has subsided, a robust labor market and Fed expectations for further hikes have seen yields rise again, only to moderate as inflationary pressures appear to ease.
“Positioning has been fragile this year, most have been on the wrong side of things,” said George Catrambone, head of fixed income at DWS Americas, which is in neutral. “You have to be careful when the Fed is nearing the end of an up cycle. Fed futures will be all over the map by September.
This week, traders reduced their holdings of two-year futures amid signs that the Fed could be on hold for an extended period after July, and instead added bets on five- and ten-year peers. Open interest in two-year U.S. Treasury futures fell 75,000 contracts in the week through Thursday, the biggest four-day drop since May.
A surprisingly hawkish Fed next week could send traders back to the drawing board once again, as could data releases on various inflation measures. While the core PCE reading for June is expected to moderate to an annual pace of 4.2%, that would still remain more than double the Fed’s long-term target.
The current strength of the workforce and the outlook for wages are paramount to bond investors.
“A resilient labor market limits the extent to which yields” can fall, said Gurpreet Gill, global fixed-income macro strategist at Goldman Sachs Asset Management, which has limited exposure to longer-term U.S. rates. “The highly plausible case is that July is the last upside in the cycle, but there is uncertainty.”
What to watch
–With the help of James Hirai.
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