Bond traders expect the gyrations convulsing U.S. Treasuries to continue in the second half of 2022 as investors challenge the Federal Reserve’s projections for how far it will tighten monetary policy to quell the worst inflation in decades.
At issue is the expected high-water mark for the Fed’s rate hiking cycle. That number has fluctuated over the last several weeks, ramping up Treasury market volatility to its highest level in more than two years as investors shift back and forth between bets on surging inflation and an economic downturn caused by the Fed’s aggressive monetary policy.
The latest twist: While the Fed’s projections show rates peaking in late 2023, investors are increasingly betting that policymakers will stop tightening early next year before easing monetary policy in the face of a looming economic slowdown.
That has helped send Treasury yields, which move inversely to prices, lower over the last week, lending support to a rally in U.S. stocks that saw the S&P 500 rise 4.5% from its lows. Benchmark 10-year Treasury yields reached a high of about 3.5% earlier this month and now stand at around 3.1%.
With markets still parsing how much the Fed’s 150 basis points of already-delivered rate hikes have impacted consumer prices, investors see few signs that the swings in Treasuries will subside anytime soon, adding more risk to a year that has already seen U.S. government bonds notch the worst start in their history.
The ICE (NYSE:ICE) BofAML MOVE Index, which measures expectations of bond market volatility, recently hit its highest levels since March 2020.
“Volatility and inflation are linked tightly together right now,” said Pramod Atluri, Fixed Income Portfolio Manager at Capital Group.
“No one really knows how far demand has to fall in order to bring inflation back down to comfortable levels. This makes predicting the Fed’s response really tricky,” he said.
The Fed, criticized for moving too slow to address burgeoning inflation, has hurried to ramp up its monetary policy response, delivering a jumbo, 75-basis point rate increase earlier in June and ramping up expectations of more big moves to come.
Fed Chairman Jerome Powell on Wednesday reiterated the central bank’s commitment to fighting inflation, acknowledging the risk of slowing the economy more than needed.
The Fed’s so-called dot-plot, which shows policymakers’ projections for where rates are headed, shows a median interest rate of about 3.8% next year, decreasing to around 3.4% in 2024.
But concerns over a looming recession have grown and investors increasingly believe the Fed will be forced to pull back from tightening monetary policy much sooner as growth starts to slow. Money markets now reflect expectations of rates topping out at nearly 3.6% by next March, compared to an expected level of about 4% in that time frame earlier this month.
“Unlike the Fed, which is pricing in the peak at the end of 2023, the market is pricing in a peak in and around the end of 2022 or early 2023,” said Eric Theoret, global macro strategist at Manulife Investment Management.“So the market is pricing in a turn in the Fed much sooner than the Fed has priced (it) in.”
How soon that high-water mark could come will likely depend on economic data, which has lately shown a mixed picture.
While the latest consumer price reading showed inflation accelerated last months to its highest level in more than 40 years, some expectations of future economic growth have wobbled.
Meanwhile, the spread between three-month Treasury bills and 10-year notes, on Wednesday was at its narrowest this year, a signal some investors believe indicates worries over future economic weakness.
Some investors see a parallel with 2021, when growing inflation began worrying markets even as the Fed insisted rising prices were a transitory phenomenon.
“U.S. government bonds are well ahead of the Fed in internalizing the growing risk of a recession,” wrote Mohamed El Erian, chief economic adviser at Allianz (ETR:ALVG) and chair of Gramercy Fund Management in a tweet https://mobile.twitter.com/elerianm/status/1540284900301049858 last week.
One risk to investors’ outlook is that factors outside of the Fed’s control, such as persistently high oil prices, keep inflation elevated and force policymakers to continue hiking rates even as growth totters, potentially leading to more losses in stocks and bonds.
“I think that inflation is going to be a lot stickier than people fear,” said Julian Brigden, co-founder and president of Macro Intelligence 2 Partners, a global macroeconomic research firm.