Bond traders give in to the Fed by scaling back their rate cut bets

(Bloomberg) — Bond traders are finally heeding one of the market's oldest lessons: Don't fight the Fed.

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As the Federal Reserve pushed through its biggest rate hike in decades, investors repeatedly misjudged how far it would go, leaving them with big losses in 2022 as Treasury bonds collapsed.

Then, early last year, they incorrectly assumed that a banking panic would force the Fed to stop. And after Chairman Jerome Powell signaled in December that he was finally done, they bet that he would move to aggressive monetary easing, with the first rate cut coming as early as March, even if the Fed forecast otherwise showed.

But investors are now taking the central bank at its word.

Derivatives markets have begun to price in that the Fed will make just four – or at most five – quarter-point interest rate cuts in 2024, just slightly more than the three announced by policymakers. That's a marked change from late last year, when futures traders bet on seven such moves, expecting the Fed to cut interest rates a full percentage point more than it telegraphed back then.

Of course, Fed officials themselves could be wrong about the direction of interest rates – as has already been the case in 2021 – but by coordinating with them on the path of monetary policy, investors are now less likely to be surprised by interest rate decisions become. This promises to provide some stability to financial markets and potentially limit investors' risk after three consecutive years in the bond market.

“We've clearly gotten a message from the Fed that they want to do some insurance cuts because they're seeing a decline in inflation,” said Ari Bergmann, founder of New York-based Penso Advisors, citing the central bank's interest in ensuring that politics does not remain so tight that the economy stagnates. “I think the market is now priced appropriately.”

The story goes on

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

But Powell has made clear he welcomes solid economic growth as long as it doesn't put upward pressure on consumer prices. There were few signs of this: Economists forecast that the Labor Department will report on Tuesday that the consumer price index rose 2.9% in January from a year earlier, the smallest increase since March 2021.

The steady decline gives the Fed room to simply cut interest rates to make policy less restrictive and prevent it from slowing the pace of the economy too much.

That expectation has helped set a floor for the bond market, as there is a general consensus among investors that there is little risk of yields falling back to last year's highs.

What Bloomberg Strategists Say:

According to positioning and banking surveys, higher returns are unlikely to be expected this year. But the minority view may well prove correct with a cyclical uptick in U.S. and global growth gaining momentum, as well as favorable seasonal times.

—Simon White, Bloomberg macro strategist

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That sentiment was reflected in strong demand at the Treasury Department's record $42 billion 10-year Treasury auction last week. At the same time, options traders have been betting that the Treasury market will remain in a stable range as it awaits the Fed's first move, which is not expected until May at the earliest.

“The Fed has three rate cuts planned for this year and the market is close to five, so the market is in line with the Fed on the direction,” said Michael Cudzil, portfolio manager at Pacific Investment Management Co.

The discrepancy is not large enough to create a risk that Fed officials will try to adjust expectations, especially given uncertainty among themselves about how the key interest rate is expected to rise at the end of the year. While most Fed officials have forecast between two and four cuts, with the median being three, they have ranged from six to no cuts.

Benson Durham of Piper Sandler & Co., a former central bank economist, says his model shows that pricing in the options market is fairly consistent with Fed forecasts.

A separate study compiled by the Atlanta Fed showed last week that options tied to the Secured Overnight Financing Rate suggested traders were betting about equal odds that policymakers would impose no more than four-quarter percent cuts in 2024 would make. At the start of the year the probability was only a third of this as the market expected easing to happen more quickly.

What you should see

• Economic data:

  • February 12: New York Fed 1-year inflation expectations; monthly household billing

  • February 13: Consumer Price Index; real average earnings

  • February 14: MBA mortgage applications

  • February 15: Initial jobless claims; retail sales; Philadelphia Fed survey; import and export price index; industrial production; capacity utilization; company inventories; TIC streams; NAHB Housing Market Index

  • February 16: Construction begins; building permit; producer price index; New York Fed services business; Sentiment and inflation expectations at the University of Michigan

• Fed calendar:

  • February 10, 12: Richmond Fed President Tom Barkin; Neel Kashkari, Minneapolis Fed President; Fed Governor Michelle Bowman

  • February 14: Chicago Fed President Austin Goolsbee; Michael Barr, Vice Chairman for Supervision of the Federal Reserve

  • February 15: Raphael Bostic, president of the Atlanta Fed; Governor Christopher Waller

  • February 16: Mary Daly, President of the San Francisco Fed

• Auction calendar:

  • February 12: Invoices for 13 and 26 weeks

  • February 14: 17 week bills

  • February 15: 4, 8 week invoices

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