Risk of U.S. Fed pausing, inflation remaining high & having to raise rates again: Strategist
Bond traders boosted bets that the Federal Reserve may re-accelerate the pace of rate increases at the policy meeting later this month, after central bank head Jerome Powell said he’s ready for faster monetary tightening if economic data justifies it.
Interest-rate swaps Tuesday showed a shift in bets for the March 22 meeting, with a half-point hike seen as more likely than a quarter-point move. Traders are betting that the Fed will raise the key borrowing costs by 107 basis points over the next four meetings to a peak of about 5.6 per cent.
Shorter-maturity notes led the jump in yields, deepening the inversion of the yield curve. An upside down-shaped curve suggests that traders anticipate a more restrictive policy that will slow down the economy significantly. The dollar jumped, while the S&P 500 tumbled 1.4 per cent.
Two-year yields jumped about 10 basis points to 4.99 per cent, while 10-year yields were little changed at 3.95 per cent. The gap between the two- and 10-year notes widened as much as 104 basis points, marking the deepest inversion since 1981. The 30-year yields were 111 basis points below two-year rates, marking a record gap between the two.
In prepared testimony before the Senate Banking Committee, Powell said the U.S. central bank is likely to raise interest rates higher than previously thought. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase” the pace of rate hikes, he said.
“He has double doses of hawkishness with potentially higher peak rates and faster pace of hiking,” said Tracy Chen, a portfolio manager at Brandywine Global Investment Management in Philadelphia. “His 25bps step-down might be premature, given the recent inflation data. This adjustment should lower the risk of Fed falling behind the curve again.”
She said it’s too early to buy long-term bonds — or to “extend duration” in Wall Street parlance — because the labor market is too tight for the Fed to relent on its tightening campaign.
“As cash becomes more attractive, there is a lesser need to stretch for yield,” she added.
In the afternoon, a government auction of US$40 billion worth of three-year notes drew record demand from non-dealers, at yields lower than expected.
A half-point increase in March would reverse the slowdown in the pace of hikes that began in December, when a half-point increase was followed by four three-quarter-point moves. Powell and his colleagues slowed the tightening further to a quarter-point move in February, bringing the policy rate to a range of 4.5 per cent to 4.75 per cent.
On Tuesday, the rate on the March overnight index swap contract rose about 9 basis points to 4.98 per cent, more than 40 basis points above the current effective fed funds rate. At that level, it fully prices in a quarter-point increase and suggests a half-point move is the most likely scenario.
Following Powell’s speech, Monetary Policy Analytics, a research firm chaired by former Fed Governor Larry Meyer, raised its forecast for the Fed fund rate at the March meeting to 50 basis points, from 25.
“The burden of proof looks significantly different after seeing Powell’s prepared remarks,” Meyer and his colleagues wrote. “Powell’s comments make it sound as though they need to be convinced not to speed the pace up. The presumption that’s been established is that they will hike 50 in March, unless they are convinced otherwise.”
Before the next policy meeting in two weeks, Powell will have more economic data to make a decision on whether a change of the tightening pace is needed, including the payroll report Friday and inflation data next Tuesday.
Powell has reinforced a view that “this a truly data-dependent central bank,” said Priya Misra, global head of rates strategy at TD Securities, and he “has injected further volatility to the pace and end point of hikes.”
“Any surprises on the upcoming payroll and CPI reports will result in a big market reaction,” she adding.