Traders Double Down On Fed Rate Cut Bets As Hike Risks Recede

Bond traders are dismissing concerns that the Federal Reserve might raise its benchmark interest rate once again and are increasingly convinced that the US central bank's next move will be to reduce it as the risk of a recession mounts. 

‍

The surge in Treasuries on Wednesday, led by intermediate and shorter-dated securities, suggests that investors are betting that Fed rates will be lower by the end of this year, despite Chair Jerome Powell's reluctance to support easier policy. 

‍

This "bull-steepening" move saw the gap between 5- and 30-year yields reach a level last seen in early 2022, even as the Fed raised its benchmark by a quarter point to a range of 5% to 5.25%.

‍

Although there was a brief moment when the rates market entertained the risk of the Fed raising its benchmark again next month, the odds of a quarter-point hike dropped significantly by the end of the day, with even swap contracts for June indicating that the effective fed funds rate will be lower. 

‍

"There are too many hurdles now to hike and the markets know it," said George Goncalves, head of US macro strategy at MUFG Securities. "Powell didn't really push back hard enough on cuts."

‍

Late on Wednesday, concern about the state of US banks added to the impetus for lower Treasury rates, with news emerging that regional lender PacWest Bancorp. has been considering strategic options, including a sale. 

‍

The 3-year Treasury yield fell as much as 17 basis points on the day to 3.50%, while the 10-year benchmark closed 9 basis points lower at 3.34%.

‍

With the monthly jobs report and consumer-price inflation numbers yet to be released this week, the swaps market suggests that Powell and his colleagues have likely finished tightening. Investors will also be watching the banking sector and the development of credit conditions closely. 

‍

The Fed's senior loan officer survey on Monday may confirm that further lending constraints are taking place. "The curve is bull steepening as the market is pricing in more rate cuts in 2024," said Priya Misra, global head of rates strategy at TD Securities. Swaps for the Fed's December meeting imply more than three quarter-point interest rate cuts by the end of 2023, with more reductions beyond that.

‍

The steepening trend between the 5- and 30-year maturities reflects a greater confidence in rate cuts. The five-year yield is trading some 38 basis points below the rate on the 30-year bond, a level last seen in early 2022 when the central bank began the process of raising its policy rate from near zero. 

‍

"As the central bank pivots to a holding stance, with potential cuts in the future, we think this is broadly positive for rates," said Greg Wilensky, head of US fixed income at Janus Henderson Investors. "In time, we would expect the yield curve to steepen from current levels."

‍

Although the steepening trend may experience some fluctuation, its overall direction is clear, according to MUFG's Goncalves. 

‍

"The steepening just takes over from around here, the big curves start steepening more and don't look back when they do." With uncertainty over when the Fed might officially indicate that it's on pause and until employment and inflation data both slow down significantly, sticking with a 5- to 30-year steepener trade remains an attractive way for some bond investors to bet on the risk of a painful recession later this year.

‍