Bond traders gear up for Fed meeting full of wildcards and risk

(Bloomberg) – The risks for bond investors from next week's Federal Reserve meeting go well beyond whether officials decide to hike rates again.

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For a market that has been betting that the central bank will move to rate cuts fairly soon, its updated quarterly forecasts for the federal funds rate and key economic indicators, due to be released on Wednesday to coincide with the interest rate decision, will be at least as important.

The rate decision is of course crucial, especially as traders remain divided on whether a June or July hike is more likely. But from this point on, the course of politics is even more decisive.

The Fed insists it is premature to consider rate cuts this year and traders are expecting no more than one rate cut. Still, there are numerous bets in options and elsewhere that an economic slowdown will require lower borrowing costs.

As such, Federal Open Market Committee members' economic forecasts and Chairman Jerome Powell's tone during his post-decision press conference could influence the reaction more than the timing of the next quarter-point hike. If they suggest conditions are peaking, bets on a pivot would rise, while more robust and restrictive forecasts would encourage bets on longer-term higher interest rates.

“The market is positioned for a long-dated recovery,” said Meghan Swiber, rates strategist at Bank of America Corp., referring to the part of the market that benefits most from falling yields, “and the last thing Supporting this view is that the Fed is done with the rate hike cycle.”

Money managers who favor long-dated government bonds or are positioning for a steeper yield curve are anticipating the end of the Fed's rate hikes, Swiber said. Bank of America's latest monthly investor sentiment survey found exposure to US dollar duration hit the highest level since 2004, beating the April 2020 pandemic highs.

Swap contracts related to future Fed meetings — which in late May had almost fully priced in a quarter-point hike in June — have downgraded that result to about one to three — still an unusual lack of consensus so close to the event. The Fed has hiked rates 10 times in a row since March 2022, and on all but two occasions swap prices have left little doubt as to the likely outcome.

The rate set in the July contract is around 5.31%, about 23 basis points above the Fed's target rate of 5.08%, with a 25 basis point hike almost fully priced in by then. For December, the contract rate is 5.07%, assuming any quarter-point rate hike from current levels will be reversed by year-end.

“The Fed is as good as dead even if it goes one or two more times,” said Arvind Narayanan, senior portfolio manager at Vanguard Group Inc. “Either the economy slows significantly into a recession that forces the Fed to cut rates, or the economy slows enough to keep interest rates at 5% for the rest of the year and then the Fed eases slowly next year.”

What Bloomberg's strategists say

“It is indeed rare for the Fed to tighten monetary policy again after a pause. This happens even less often when tariffs are already restrictive.”

— Simon White, macro strategist

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Inflation data to be released early Tuesday could prove crucial. The CPI growth rate is expected to slow from 4.9% to 4.1% in May and from 5.5% to 5.2% excluding food and energy. The Fed targets inflation averaging 2% over time.

Economists at Citigroup Inc., who expect a rate hike in June, are basing this forecast on May CPI readings, which they predict will show underlying inflation staying closer to 5%, said Andrew Hollenhorst, chief economist for the US at the bank, in a video released Thursday.

Ahead of the session signals from the Treasury market could be distorted by unusually large fresh supply compressed into two days. In addition to monthly sales of 3- and 10-year bills and 30-year bonds, which are normally spread over three days, $206 billion in Treasury bills are scheduled to be sold to replenish state coffers, which have been exhausted to the federal debt limit was suspended last week.

Expectations of further rate hikes by the Fed peaked in early March this year, when Powell said policymakers are ready to accelerate the pace of rate hikes again if economic data warrants it. The yield on the two-year Treasury bond, which is more sensitive to changes in the Fed's interest rate than longer maturities, briefly topped 5 percent. It has stabilized at around 4.6% as the case for further rate hikes has been dampened by several regional bank failures and other signs that the economy is finally beginning to face tighter financing conditions.

“We think it's more likely that the Fed will skip July,” said Thomas McLoughlin, head of fixed income for the Americas in the chief investment office of UBS Group's wealth management division. “But Powell's message was that he intends to maintain tight monetary policy at least through the end of the year and possibly into next year.”

What to see

  • Economic data calendar

    • June 12: Monthly budget statement

    • June 13: Consumer Price Index; NFIB Small Business Optimism

    • June 14: MBA Mortgage Applications; producer price index

    • June 15: Retail Sales; unemployment claims; import and export price indices; Empire manufacturing; Philadelphia Fed Business Outlook; industrial production; corporate inventories; Treasury International Capital Flows

    • June 16: New York Fed services deal; Sentiment and inflation expectations at the University of Michigan

  • Federal Reserve calendar

  • auction calendar

    • June 12: 26- and 13-week bills; 3 and 10 year bonds

    • June 13: 52-week bills; 42-day cash management invoices; 30-year bonds

    • June 14: 17-week bills

    • June 15: 4 and 8 week bills

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