Bond traders preparing for gradual interest rate cuts starting in September are increasing side bets in case a sudden downturn in the U.S. economy forces the Federal Reserve to take more aggressive measures.
Investors fully priced in at least two rate cuts this year, slightly ahead of policymakers’ telegrams, as U.S. Treasuries rose for a third straight month. In derivatives markets, some traders have gone even further with bets that central bankers will be rewarded if they boldly cut interest rates by half a percentage point in mid-September, or sooner.
While still an anomaly, speculation surrounding the need for such a move has gained traction amid evidence that businesses and consumers are feeling the pinch from two years of high base rates. Even as inflation has eased, investors are increasingly concerned that the labor market is about to collapse – something Fed officials say they will adjust to. The large time gap between the July and September policy meetings increases risks.
“It’s fair to say that if the labor force shows more signs of weakness, then the economy will be in worse shape and the Fed will cut interest rates further,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “We don’t know what that’s going to look like. cutting cycle.”
Last week, former New York Federal Reserve Presidents William Dudley and Mohamed El-Erian said the central bank may have made a mistake by keeping interest rates too high for too long, with Dudley even calling for a move this week action was taken at the policy meeting, anxiety reached a new level. Both are Bloomberg opinion columnists.
The comment alone was enough to roil markets, causing policy-sensitive short-term U.S. yields to plummet in a so-called steepening pattern that is customary before easing cycles. Still, green data on jobless claims, U.S. economic growth and consumer spending helped bolster the central bank’s case for tightening monetary policy this week.
Michelle Girard, head of U.S. operations at Natwest Markets, told Bloomberg TV on Thursday that the data “removes the urgency that the Fed must take action.” “The Fed doesn’t want to appear panicked.”
Despite some recent turbulence over election concerns, expectations of imminent rate cuts have generally boosted U.S. Treasuries, causing yields to fall significantly from their peaks in late April. The Bloomberg U.S. government debt index hit a two-year high this month and was on track to end July on a three-month winning streak in mid-2021.
Policymakers have kept their one-year target rate at 5.25% to 5.5% while awaiting signs that inflation is continuing to cool. With prices appearing to be heading in the right direction — data on Friday showed the Fed’s preferred measure of inflation rose at a moderate pace in June — they are starting to pay more attention to the other side of their so-called dual mandate: to fully employment.
In this regard, the next few months will be crucial – including next week’s jobs report. George Catrambone, head of fixed income at DWS Americas, said evidence of real weakness “could create new soft landing issues, with the Fed potentially falling back behind the curve and missing out on a rate cut in July.”
With the Fed widely expected to remain on hold, Chairman Powell may use Wednesday’s news conference to raise new economic concerns or policy changes.
If he starts laying the groundwork for more rate cuts than expected, it would send a dire signal: Only after the dot-com bubble burst in early 2001 and the financial crisis erupted in September 2007 did the Fed deliver on half of its rate-cutting goals. scale easing cycle.
JPMorgan Chase & Co.’s Michael Feroli doesn’t expect such a shift. He said in a note on Friday that he expected Powell to “avoid pointing to any specific meeting for a first rate cut.” As for answering a question about not cutting interest rates this month, Powell is likely to say the central bank chief wants further evidence of progress in inflation, the report said.
George Goncalves, head of U.S. macro strategy at Mitsubishi UFJ Financial Group (MUFG), believes that by September, there will be more signs of economic weakness, which may prompt the Federal Reserve to take preemptive measures. .
“The idea of slow and steady cuts makes no sense given where the data is going,” Goncalves said. “The longer you wait, the more you may have to do later.”
Some in the market believe there is enough uncertainty to warrant a just-in-case bet. In recent weeks, traders have used options tied to the covered overnight funding rate, which closely tracks the Fed’s policy expectations, to prepare for longer-term scenarios such as a quarter-percentage-point move starting as early as July, or in down half a percentage point in September.
“When a 25 basis point cut is fully priced in, you only have two options,” said Ed Al-Hussainy, interest rates strategist at Columbia Threadneedle Investment. “You can target 0 or you can target 50.”
Derek Tang, an economist at Washington policy analysis firm LH Meyer, said the current “macro situation does not require or even justify” rapid easing. He said officials were more likely to choose to cut rates by a quarter of a basis point per meeting, or 50 basis points per quarter, before trying a sharp cut of half a basis point.
Going from being on hold for more than a year “to suddenly doing 50 things means something has happened and it doesn’t taste good,” Al-Hussainy said.
