Investors have been quick to up their bets that the Federal Reserve will cut US interest rates this year on a busy trading day that weighed on the functioning of markets.
The turmoil was so great that the main US futures exchange temporarily halted trading in certain interest rate contracts. Traders who removed risk widened the gap between bid and bid prices for US Treasuries. Deals in the $22 trillion Treasury market — the deepest and most liquid in the world — took longer and were more expensive to execute.
Market moves on Wednesday came a week before the Fed is scheduled to decide on interest rate levels at its next monetary policy meeting after months of hikes last year. Many bond traders now expect the Fed not to hike rates, although some still see a chance of a 0.25 percentage point hike as it fights stubborn inflation, according to futures market pricing. As recently as last week, markets were dominated by expectations of a half-point rise.
Prices in futures markets suggested the Fed could start cutting rates by a quarter point as early as June and make further cuts to bring the central bank’s benchmark rate to 3.9 percent, more than 1 percentage point below expectations would peak at 4.9 percent in May.
Interest rate expectations have shifted over the past week after last week’s collapse of Silicon Valley Bank and two others sparked fears of a broader banking crisis.
Rapidly changing interest rate forecasts triggered price swings that forced exchange operator CME Group to halt trading in certain contracts linked to the Sofr benchmark for borrowing and federal fund futures markets for two minutes. Trading has since resumed.
“There’s a circuit breaker that goes off when these futures move more than 50 basis points, and that’s what happened this morning,” said Tom Simons, a money market economist at Jefferies.
Traders said such a stop is rare as these interest rate futures markets typically move in small increments based on Fed signals and official data.
The yield on the two-year government bond, which is more sensitive to interest rate expectations, fell 0.27 percentage points to 3.98 percent on Wednesday. It has fallen from more than 5 percent last week in moves not seen since the late 1980s.
The yield on 10-year Treasury bills fell 0.21 percentage point to 3.4 percent. Bond yields move inversely with prices.
“Some market participants expected the Fed to keep hiking until something broke. The question now is, was that it?” said Michael de Pass, global head of linear rates trading at Citadel Securities, referring to the bank sell-off.
Fluctuations in the Treasury market were large enough to widen the spread between bids and offers for Treasuries, making the securities more difficult to buy and sell.
“The liquidity is gone and could continue to deteriorate,” said Michael Lorizio, a fixed income trader at Manulife. “It makes sense that bid-ask spreads have widened given the volatility.”
The cost of trades has increased, although investors still said it was possible to make deals. A portfolio manager said: “We do deals of all sizes over the phone and negotiate prices more carefully. Going to the screens to run them electronically is painful.”
While some of the shift in futures markets is related to expectations for Fed policy, traders said it was also likely to reflect the unwinding of leveraged positions that had built up since the beginning of the year.
“Speculators have been so tight on bonds for some time,” Simons said. “Now we had a risk event and it was a struggle to cover those positions.”
That rise was echoed in data from the Commodity Futures Trading Commission, which revealed the largest short position on record — a bet for higher rates — in two-year government bonds in mid-February. The CFTC data is typically released weekly but has been delayed due to a recent cyberattack on Ion Markets, a financial technology group that serves derivatives markets.
Interest rate expectations initially began to shift after concerns over the fate of the Silicon Valley bank surfaced late last week. They fell further on Wednesday after Credit Suisse said its largest shareholder would not provide any more capital to the Swiss bank.
Meanwhile, the US reported that producer prices fell 0.1 percent in February while a slight increase was expected. Wednesday’s report softened Tuesday’s news that US consumer prices continued to rise as inflation data put pressure on the Fed to hike rates further.
“If we take a step back, the Fed has done quite a bit in terms of the hiking cycle. And if you look at when the migration cycle started, we’re now at the point where you would really expect the migration impact to start in earnest,” said de Pass of Citadel Securities.