Treasury Market’s Great Bearish Trade Gathers Momentum

(Bloomberg) — The bond market is zeroing in on a U.S. recession next year, with traders betting on a downward long-term trajectory for interest rates even as the Federal Reserve is busy raising policy rates.

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Long-term Treasury yields are already below the Fed’s overnight benchmark range – currently 3.75% to 4% – and there is still an additional percentage point of central bank hikes expected in the coming months. There has also been activity in the options market, suggesting some are hedging the risk that policy rates could halve from current levels.

Instead of waiting for definitive economic evidence that this year’s frenetic monetary tightening will provide the conditions for a recession in 2023, investors are buying bonds — a position advocated by Pacific Investment Management Co., among others.

“Fed policy is dynamic and they’re still indicating they’re going to go higher,” said Gregory Faranello, head of U.S. interest rate trading and strategy at AmeriVet Securities. “But the market trades thinking the Fed is more comfortable with the end.”

Demand for longer-dated Treasuries pushed the 10-year and 30-year yields below the lower end of the Fed’s overnight range this week. With front-end rates remaining relatively stable, it saw the most marked inversion of the yield curve intensify in four decades — a widely watched indicator of potential economic pain ahead.

“The recession indicator narrative is strong, but from the Fed’s perspective, it’s part of the solution,” Faranello said.

The US economy, especially the labor market, has so far shown itself to be quite resilient in the face of interest rate hikes by the Fed, which has been trying to curb high and apparently persistent inflation. That’s why investors will be closely attuned to next Friday’s monthly jobs report for signs of a crackdown, or signs that the Fed may be ready to change policy course.

They will scrutinize the words of Fed Chairman Jerome Powell and his colleagues, who will make their last public appearance next week before moving into a routine drafting period ahead of the Fed’s Dec. 13-14 policy meeting. Officials were adamant in reiterating the need for policy rates to rise above current levels, although the minutes of their most recent meeting indicated they would soon slow the pace of tightening.

At this point in the cycle, the Fed’s jawbone may be less effective than the tone of the data, given expectations for a gradual easing of policy tightening from here on the perception that inflation has peaked and job creation is slowing.

The magnitude of the bullishness in the long end of the bond market right now – and the depth of the yield curve inversion – means there could be some turbulence for Treasuries next week as traders handle a series of top-tier data. , not just a job report. Recession bets could be helped by a projected contraction in the ISM manufacturing gauge, while the personal income and expenditure report will show how things are faring in personal consumption expenditures, the Fed’s preferred measure of inflation. Figures on the number of new jobs are also planned to be released.

Current exchange market prices point to the effective fed funds rate rising to around 5% by the middle of next year, followed by a decline to more than half a percentage point by early 2024. But some are betting on a sharper turn. , with auctions this week of Secured Overnight Financing Rate futures focusing on the possibility of a drop to 3% or even 2% in late 2023 or early 2024.

However, there is resistance in some quarters to the current bond market consensus about the Fed, the economy and, of course, the eventual return of low inflation next year. This week Goldman Sachs Group Inc. It said the 10-year would trade above 4% until 2024, as expectations for rate cuts next year will be dashed if the economy does not enter recession and inflation remains high.

It’s far from the central picture, though. Market prices suggest that even if the Fed itself is not yet focused on policy, many investors are increasingly turning away from the risk of relentless Fed hikes and a possible economic recession.

What to look at

  • Economic calendar:

    • November 28: Dallas Fed manufacturing activity index

    • November 29: Conference Board consumer confidence; FHFA home price index

    • November 30: ADP employment; MBA mortgage applications; third quarter gross domestic product; trade balance of advance goods; wholesale and retail; MNI Chicago purchasing managers’ index; pending home sale; JOLTS jobs; Fed beige book

    • December 01: Statement of personal income and expenses, including PCE; weekly unemployment claims; ISM production

    • December 02: Monthly business report

  • Fed calendar:

    • November 28: New York Fed’s John Williams; James Bullard of Louis Fed

    • November 30: Chairman Jerome Powell; Governors Lisa Cook and Michelle Bowman

    • December 01: Michael Barr, Vice Chairman of Oversight; Lori Logan of the Dallas Fed; Bowman

    • December 02: Charles Evans of the Chicago Fed

  • Auction calendar:

    • November 28: 13-week and 26-week accounts

    • November 29: 52-week bills

    • November 30: 17 weeks of bills

    • December 01: 4-week, 8-week bills

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