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Bond Traders’ Fortunes Hinge on Where Fed’s Rate Comes to Rest

·4 min read

(Bloomberg) -- The fate of many large wagers in the US bond market hinges not only on the size of the Federal Reserve’s next rate increase on Wednesday, but maybe even more so on its revised forecasts for where the policy rate will ultimately come to rest and how long it’s likely to stay at that level.

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In the past week, market-implied expectations were ratcheted higher after the latest monthly inflation data showed less moderation than expected. Swap contracts that forecast rates over the next two years now peak at 4.5% in March 2023, a full point higher than was expected after the Fed’s last meeting in July. Meanwhile, the most recent year-end forecasts by Fed policymakers -- the so-called dot-plot, formulated in June -- are nearly all below 4% for 2022-2024.

The shift featured a bundle of wagers -- with millions at stake -- that the peak will be around 5%, if not higher. Others are betting on an end-2023 rate of around 4.5%, whereas the broader market expects a decline to around 4% by that time. While next week’s policy decision may move markets if bigger than the three-quarter-point hike most expect, the revised dot plot and Fed Chair Jerome Powell’s vision of the future will matter more to some of those wagers.

“The September FOMC policy action certainly matters, but it’s a little bit of not seeing the forest for the trees,” said Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, which manages about $17 billion in assets. “From our perspective, as investors who really focus on the next 6 to 12 to 18 months, it’s less about one meeting but more about the cumulative” Fed rate moves. “We expect Powell will also give another hawkish message.”

August inflation data released Sept. 13 led the market to fully price in a third consecutive three-quarter-point rate increase on Sept. 21 -- bringing the target range for the federal funds rate to 3%-3.25% -- and to assign non-zero odds to a full-point hike. The US central bank has raised rates four times since March in response to accelerating inflation. The rate hikes follow a two-year period when the lower bound was 0%.

At the same time, resilience in employment has spurred revisions to forecasts for next year. JPMorgan Chase & Co. economist Michael Feroli now expects a half-point hike in November, up from a quarter point, and quarter point moves in December and February, taking the terminal rate to 4.25%. And if the labor market hasn’t shown clear signs of cooling by then, “then we’d look for the Committee to continue tightening in 25bp moves until that occurs.” Bloomberg Economics’ chief US economist Anna Wong predicts the terminal rate will be 5%.

In the June dots, the median projections for fed funds are 3.4% at year-end, 3.8% a year later and 3.4% at end-2024. Economists at Citigroup Inc. predict that the medians will rise to about 4.25% for 2022 and 4.5% for 2023. Strategists at BMO Capital Markets predict that the updated dots will point to terminal rate in the 4.25%-4.5% area.

David Robin, a strategist at TJM Institutional, who’s been working in debt derivatives for decades, said the new dots might show a persistent trend higher in rates as opposed to a decline in 2024.

Notable trades in debt derivatives this week appear to anticipate a peak Fed rate in the range of 4.75% to 5.25% -- levels last seen in 2007. Among the biggest is a SOFR options hedge structure predicated on the policy rate ending next year at 4.5%.

Read more: Options Traders Pile Into Hawkish Fed Wagers Eyeing 5% Peak Rate

In the Treasury bond market, sentiment around the Fed has driven two- to five-year yields to the highest levels since 2007, while longer-maturity yields have been relatively contained by expectations that Fed policy will eventually crash the economy. Two- and five-year yields exceeded 30-year yields this week by the most since 2000.

“The shorts are in control, and the market led by the two-year will follow the magnetic pull of a higher terminal rate,” said George Goncalves, head of macro strategy at MUFG. “The focus at the moment -- via the dots -- is how far can the Fed push this? The only viable outlet for the Fed is tighter financial conditions, and this is a meeting where they should be happy the market is pricing in a more aggressive policy path.”

What to Watch:

  • Economic calendar:

    • Sept. 19: NAHB housing market index

    • Sept. 20: Housing starts

    • Sept. 21: MBA mortgage applications; existing home sales

    • Sept. 22: Weekly jobless claims; current account balance

    • Sept. 23: S&P Global US manufacturing, services and composite PMIs

  • Fed calendar:

    • Sept. 21: Federal Open Market Committee rate decision and press conference

    • Sept. 23: Fed Chair Jerome Powell at Fed Listens Event

  • Auction calendar:

    • Sept. 19: 13- and 26-week bills

    • Sept. 20: 20-year bonds

    • Sept. 22: 4- and 8-week bills; 10-year TIPS

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