Bond traders give in to Fed, withdraw bets on rate cut

Bond traders are finally heeding one of the market’s oldest lessons: Don’t fight Fed.

As the Fed enacts its biggest rate hike in decades, investors Always been misjudged They stand to take huge losses in 2022 as national debt plummets.

Then early last year, they mistakenly betting A banking panic will force the Fed to halt action. In December, Chairman Jerome Powell said he was done for, and they were betting he would shift to aggressive easing, with a first rate cut coming as early as March, although the Fed predicted otherwise.

But investors now take the central bank’s word for it.

In derivatives markets, they have come to expect the Fed to cut interest rates just four or as many as five quarter-percentage points in 2024, just above the three percentage points expected by policymakers. Late last year, futures traders placed bets on seven such moves, predicting the Fed would cut interest rates by a full percentage point more than what was telegraphed at the time.

Of course, Fed officials themselves could be wrong about the direction of interest rates — as happened in 2021 — but by keeping pace with them on the path of monetary policy, investors are now less likely to be caught off guard by a rate decision . It is expected to provide a degree of stability to financial markets and potentially limit investors’ risk after three consecutive years of heavy losses in bond markets.

“Clearly we’re getting the message from the Fed that they want to do some insurance cuts because they’re seeing inflation come down,” said Ari Bergmann, founder of New York-based Penso Advisors. He was referring to the central bank’s desire to ensure policy was not compromised. ” remains so tense that it has brought the economy to a standstill. “I think the market is priced appropriately right now.

The Fed’s direction will depend on whether inflation continues to subside, so the outlook could change.

But Powell made it clear that he welcomed solid economic growth as long as it did not put upward pressure on consumer prices. There are few signs yet: Economists predict that the Labor Department will report on Tuesday that the consumer price index rose 2.9% year-on-year in January, the smallest increase since March 2021.

The steady retreat gives the Fed room to lower interest rates just to make the policy less restrictive and prevent it from causing too much of a drag on the pace of the economy.

That expectation helped set the stage for the bond market, given that investors generally see little risk of yields returning to last year’s peaks.

This feeling is Demand The U.S. Treasury Department held a record auction of $42 billion in 10-year Treasury notes last week. Meanwhile, options traders have been betting that the U.S. Treasury market will remain in a stable range as it awaits the first steps from the Federal Reserve, which is not expected to take action until May at the earliest.

“The Fed has had three rate cuts this year and the market has had almost five, so the market is directionally aligned with the Fed,” said Michael Cudzil, a portfolio manager at Pacific Investment Management Co.

The difference isn’t big enough to create a risk that Fed officials will try to reset expectations, especially given the uncertainty among them about where policy rates might be by the end of the year. While most Fed officials expect between two and four rate cuts, the median is three, with the number of cuts ranging from as many as six to none.

Benson Durham of Piper Sandler & Co., a former Fed economist, said his model shows options markets are pricing in very consistent with the Fed’s forecasts.

A separate report tracked by the Atlanta Fed last week showed options tied to the guaranteed overnight funding rate showing traders were roughly even on the odds that policymakers would cut interest rates by no more than a quarter percentage point in 2024. Only one-third of them are expected, and the market is expecting a faster pace of easing.

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