(Bloomberg) — Amid signs that the bond market is buying in the Federal Reserve to keep interest rates on hold for longer, a host of investors are betting on the economy’s wall — and a policy shift in the near term.
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Data showed that Treasury yields remained in tight territory this month, at their highest level in more than a decade, and that inflation remained above the Fed’s 2 percent target. But with yields expected to peak at the pace of policy, the growth outlook takes on greater significance.
Last week saw demand for options that would yield profits if interest rates were to decline before the middle of next year. That’s a more dire scenario than what traders see in the options market in the first half of 2024.
Bond traders have been placing such bets since the beginning of the hiking cycle. But this time could be different, as the Fed’s tightening cycle has plenty of time to work its way through the economy.
The Fed is widely expected to leave the policy rate unchanged next week after raising it for the 10th time in July in a vigorous hiking cycle that began in March last year. It has seen it significantly raise its growth forecast and signal another rate hike this year in its so-called points plan. The 2024 price estimate remains up for debate. In June, the median forecast showed a percentage point decline by the end of next year.
As long-term rates rise, the risk of deflation increases, and there are signs of consumer distress as higher borrowing costs at the margin and weak employment begin to erode household spending. As the Fed nears the top of its policy stance, the focus is now on easing growth.
“There is a question mark around whether the economy is moving into a soft landing or whether the labor market will weaken to a bearish outlook,” said Roger Hallam, global head of pricing at Vanguard Asset Management.
The week saw interest in options linked to an expected overnight financing boom, hedging several rate cuts ahead of June. These trades may be accompanied by existing positions that reflect the Fed’s current message, allowing some traders to benefit from a surprising policy pivot.
A transaction is set for a 3% rate in the middle of next year and around 5% with the current market level. The premium paid on that bet was over $10 million. Other similar transactions around March were also made during the week.
The rate stimulus that the Fed could bring to rate cuts in mid-2024 or earlier is in stark contrast to policymakers who are worried about the long-term narrative. Meanwhile, the Fed’s current rate of 5.25%-5.5%, above US annual inflation and the three-month annualized figure, threatens the growth outlook.
Read more: The bond market has never sounded the alarm for this long recession
As a result, investors are more worried about the recession than nine months ago, according to Robert Waldner at Invesco.
The chief strategist said, “The downside risk is increasing as rates remain high and nominal growth slows.” “The central bank’s policy is tightening as inflation is falling, and if it doesn’t take this into account, it will increase risk.”
Holding options ahead of next year’s Fed meetings in March and June could make sense, as the bond market is likely to remain in content mode as investors wait for clarity on the economy.
According to Vanguard’s Hallam, it makes sense to see low yields in an economic environment heading into recession. But if higher energy prices halt recent inflation, the picture for bond buyers will be complicated.
“Stuck inflation will make it very difficult for the Fed to ease next year,” he said.
With the outlook for the economy and uncertainty about rates, parking money has been gaining favor over cash-like counterparts. This year, EPFR fund data shows that short-dated Treasuries returning 5%-plus have seen significant inflows, locking in relatively high yields.
For Amundi Institute’s head of the Monika Defense, the middle of the Treasury curve looks attractive for a multi-strategy portfolio.
When rates are longer, yields should be lower as the economy weakens, and the five- to 10-year sectors are “a good alternative to stocks,” he said.
What Bloomberg Economics Says…
Fed cautious to keep US rates on hold, but keeps options open. “If the labor market slows for the rest of the year, as we expect, and the unemployment rate falls to 4.1% in line with economic forecast forecasts, the Fed may continue to hike rates.”
– Anna Wong, America’s chief economist
For the full note, click here
What should be seen
Economic data calendar
September 18: New York Services Business Activity; NAHB Housing Market Index; TIC flows
September 19: Building Permits; Housing begins
September 20: MBA mortgage applications
September 21: Current Account Balance; Initial unemployment claims; Philadelphia Fed’s Business Outlook; Current home sales; Leading index
September 22: S&P Global US Manufacturing, Services and Composite PMI
Federal Reserve Calendar
September 20: Federal Open Market Committee policy statement and summary of economic forecasts; Federation Chairman Jerome Powell’s press release
September 22: San Francisco Federation President Mary Daly; Governor of the Federation Lisa Cook
September 18: 13- and 26-week accounts
September 19: 42 days of cash management accounts; The 20-year bond will reopen.
September 20: 17-week accounts
September 21: 4- and 8-week bills; 10-year Treasury inflation-protected securities
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