(Bloomberg) — Battered by decades of wild swings, bond investors are getting down to their next big test: navigating the Federal Reserve's response to growing financial instability that threatens to derail its fight against inflation.
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No matter what the central bank does, investors face more pain following increased volatility levels since the 2008 financial crisis. The recent slide in Treasury yields and a sudden reset in the Fed rate bet suggest another 25 basis-point hike is the most likely scenario at this level. Now Wall Street is getting really worried about what the executives will do after that.
Traders currently see the central bank's benchmark ending around 3.8%, more than a full percentage point below the Fed's rate estimate in the December “dot plot” that comes as part of the quarterly economic projections . It's a soft scenario that could hit a wall on Wednesday when new forecasts emerge.
Inflation remains high and the labor market has shown resilience despite the most aggressive tightening campaign in decades. Whether the Fed chooses to focus on that or prioritizes concerns about the health of the financial system could set the path for further rates.
“It's a two-sided risk now, and maybe even more,” said rates market veteran David Robin, a strategist at TJM Institutional in New York. “The only Fed move that is definitely off the table is a 50 basis-point hike. Otherwise, there are many policy possibilities and even more response-action possibilities. It's going to feel like an eternity until 2 p.m. next Wednesday.”
Amid all the anger, the widely watched MOVE index, an options-based measure of expected volatility in Treasuries, hit 199 on Wednesday, nearly doubling from late January. The yield on US two-year notes, typically a less risky investment, swung between 3.71% and 4.53% this week, the widest weekly range since September 2008.
The Federal Open Market Committee will hike rates by a quarter point from the current 4.5%-4.75% range at its March 21-22 meeting, according to economists polled by Bloomberg News. Fed Chair Jerome Powell has raised the possibility of a return to larger moves, meaning a half point or more if based on economic data. But not before concerns about the banking system spooked the markets.
Even with the turmoil engulfing Credit Suisse Group AG and some US regional lenders, the European Central Bank plans to hike by half a point on Thursday – but with little clue on what might happen later Given.
The issue now is whether the recent banking crisis will constrain the Fed's ability to deal with price increases that, while moderating, remain well above the 2% target.
“The most painful outcome would be a Fed that comes in and says we have this financial stability issue, and it's going to be resolved,” said Ed Al-Husseini, rate strategist at Columbia Threadneedle Investments. Then, the Fed will be able to stick to its fight to tighten and contain inflation, he said. “This is an outcome the market is not ready for at this stage.”
This begs the question whether the shift in market pricing has now gone too far.
Back in December, US officials predicted they would raise rates at a slower pace, with the average estimate putting the benchmark at 5.1% in late 2023. Following Powell's remarks to US lawmakers on March 7, bets for the new dot plot showed additional tightening – swaps traders raised expectations for the peak rate to around 5.7%.
Those bets were quickly wiped out amid fears of a wider banking crisis that could lead to a credit crunch at a time when bets on an economic downturn are running rampant. Now swaps traders are betting that the Fed's tightening will only peak at 4.8% in May, with rates coming down through the end of 2023.
Any flamboyant surprise from the Fed's dot plot will spook investors — especially after the big rally in Treasuries this month.
For Anna Dreyer, co-portfolio manager of the Total Return Fund at T. Rowe Price, the only certain thing amid all the uncertainty is the “tug of war” between banking contagion and inflation concerns. That will continue to be the driving sentiment in the rates market.
“We don't know how far they tighten and what the impact is on US growth and the economy,” said Ashish Shah, chief investment officer for public investments at Goldman Sachs Asset Management. “Banks are going to set a higher limit for lending and this will have the effect of slowing down growth. The conclusion for investors is that they should price in more uncertainty for interest rates in either direction.
what to watch
economic data calendar
March 21: Philadelphia Fed Manufacturing Index; Existing Home Sales
March 22: MBA Mortgage Application
March 23: Jobless claims; current account balance; Chicago Fed National Activity Index; new home sales; Kansas City Fed Manufacturing Index
March 24: Durable goods orders; capital goods orders; S&P Global US Manufacturing and Services PMI; Kansas City Fed Service Activity
federal reserve calendar
March 20: 13- and 26-Week Bills
March 21: 52-week bill; 20 years bond
March 22: Bill for 17 weeks
March 23: 4- and 8-week bills; 10-Year Treasury Inflation Protected Securities
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