Bond Investors at Crossroads With Fed Break

(Bloomberg) — The emerging consensus that the Federal Reserve will raise rates only once or twice has created new dilemmas for bond investors, who must now decide which parts of the market will fare better under the circumstances.

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The U.S. Treasury market hit a turning 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 said 15 minutes later he favored another rate cut. Market expectations for the central bank’s February meeting shifted to a quarter-point increase instead of a half-point, giving small odds to no action in March for the first time.

Short- and intermediate-term yields fell sharply to three-month lows, while the 10-year fell below 3.5%, extending a rally from around 3.8% earlier in the year. Much uncertainty remains; Earlier this week, two other Fed officials predicted the Fed’s overnight benchmark would remain above 5%. But investors are leaving the threat of higher policy rates behind as they finally set their positions.

“The market has discounted all its language about the Fed raising rates above 5%,” said Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investments. Having favored long-term bonds in recent months, he expects intermediate sectors to perform best near the end of the hiking period. Finally, “Once the Fed tells us this is the last hike — and March is a decent bet around that — then the front is there to take.”

Bond investors were hammered by rising yields last year as 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 had peaked allowed the Fed to ease the brakes with a half-point hike after four straight three-quarter-point moves in December. A recent slowdown in the pace of consumer price growth in December – excluding food and energy, the rate was 3.14% in the fourth quarter, a 15-month low – set off a wave of trade.

The expected peak for the overnight rate in swap contracts, which refer to Fed meeting dates, fell to 4.9%. The Feb. 1 decision calls for a total of 29 basis points of hikes — making a quarter-point better than a half-point — and pricing in fewer than 50 basis points by March.

A flurry of bets in short-term interest rate options following the inflation data expected an imminent end to Fed rate hikes and further declines in market volatility. They included a large copy stating the idea that the cycle would stop after February.

“The path of short-term rates is tied to inflation, and there’s a fluctuation factor around that depending on how strong or weak the economy looks,” said Jason Pride, chief investment officer at Private Wealth at Glenmede. “If inflation continues at 6% and 7%, you need a 5% funds rate, not when inflation goes back to 3% and you could see headline inflation around 3% in the middle of the year.”

Beyond the short-term exchange rate market, the new framework has spurred bets on additional Treasury market gains.

In Treasury futures, Thursday’s rally resulted in a large increase in open interest — the number of contracts with positions — especially for the 10-year and 5-year note contracts. The increase was equivalent to buying $23 billion of the most recently issued 10-year note, about 20% of the outstanding amount.

The 10-year Treasury yield, which peaked at around 4.34% last year, could retreat to around 2.5% within six months if the inflationary trend continues, Al-Husseini said.

“A lot of the risk premium at the long end of the curve reflects inflation, and if it falls faster or even at the current rate, there’s a lot of runway for repricing at the long end,” he said.

It might be too soon. After sharp gains in the Treasury market, a period of consolidation can be expected.

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

Treasury yields were higher last year with maturities as short as two years, which remain the highest-yielding segment of the market at around 4.21%. PGIM expects this trend to reverse, but it may take some time.

“The bullish is the right trade for this year, and it really starts once the Fed is done hiking,” he said.

What to look at

Economic calendar:

  • January 17: Empire Productions

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

  • January 19: Housing 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 Lori Logan

    • January 19: Boston Fed President Susan Collins; Vice Chairman 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; 10-year Treasury inflation-protected securities

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