Bond traders are near wiping out bets that the Federal Reserve will lower interest rates this year after the central bank held its key rates steady and signaled more monetary tightening would likely be necessary to cool inflation.
(Bloomberg) — Bond traders are near wiping out bets that the Federal Reserve will lower interest rates this year after the central bank held its key rates steady and signaled more monetary tightening would likely be necessary to cool inflation.
Rates on swap contracts referencing future Fed policy meetings reflect a peak rate of about 5.30% in September after the central bank’s decision, while the December 2023 contract’s rate jumped to about 5.20%.
That year-end rate was about 15 basis points below the expected peak as recently as Wednesday morning, implying most of a quarter-point rate cut. Longer-dated contracts continue to anticipate easing in 2024.
The Fed left its policy rate unchanged at 5%-5.25% Wednesday after 10 consecutive increases, as most forecasters expected. Revised quarterly forecasts for the economy and monetary policy, however, showed officials expect to resume tightening to cool inflation, projecting more increases than economists and investors expected.
While traders have subsequently pared back their expectations for 2023 easing, they’ve yet to fully price in the degree of policy tightening signaled by the Fed. Swap contracts tied to Fed meeting dates fully price in only about one quarter-point rate increase through the end of the year — compared to about 50 basis points of tightening implied in the policymakers’ so-called dot plot.
Officials’ offered a median forecast of 5.6% in their so-called dot plot for the end of 2023, compared to the 5.1% median released in the March.
The yield on two-year Treasuries oscillated widely — rising as much as 13 basis points in the wake of the Fed’s decision and release of officials rate projections. Those gains were soon pared as Fed chairman Jerome Powell made clear that the July gathering would be a “live” meeting.
“Powell did not want to lock himself in,” Seth Carpenter, chief global economist at Morgan Stanley said on Bloomberg Television. Also, “one way to interpret the rates-market reaction, which is not fully pricing in what the dot plot says, is that the market understands that the Fed’s decisions will be dependent on incoming data.”
The view that the Fed would shift to cutting rates this year was well-entrenched until recently. In early April, as US regional bank shares slumped after several institutions failed, about three quarter-point cuts were priced in. It has eroded amid surprising resilient US labor-market indicators and inflation readings still well above the Fed’s target.
“The Fed caused heartburn with their estimates of future rates, implying their concern for high inflation outweighs the softening in growth we are experiencing,” Jeff Klingelhofer, co-head of investments at Santa Fe, New Mexico-based Thornburg Investment Management, said in an emailed comment.
Read More: Fed Dot Plot Offers Clues on Appropriate Pace of Change
Of course, traders still price in a modicum of chance that the Fed reverses course on policy before 2023 comes to an end. And a full quarter point of Fed rate cuts is now priced in by around May 2024 — an indication that markets are still unaligned with Powell and his colleagues.
“It will be appropriate to cut rates at such time as inflation is coming down really significantly, and we’re talking about a couple years out,” Powell said during his press conference. “Not a single person on the committee wrote down a rate cut this year, nor do I think it is at all likely to be appropriate.”
–With assistance from Anya Andrianova and Edward Bolingbroke.
(Adds market moves, context and commentary throughout.)
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