Powell wins against bond traders who are cutting their bets on a deep downturn

(Bloomberg) – The bond market is finally in line with Jerome Powell's economic outlook.

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Traders have abandoned their once-aggressive bets that the Federal Reserve Chairman would ease monetary policy later this year. This reflects heavily muted expectations that central bank rate hikes will trigger a sharp recession. Bond yields have rebounded to pre-Silicon Valley Bank collapse panic levels.

And even if policymakers see the chance of two more rate hikes in the coming months, the US economy is expected to hold up reasonably well, in contrast to Europe, which is showing signs of stagnation.

“The signs are that the Fed will not cut rates this year,” said Greg Peters, co-chief investment officer of PGIM Fixed Income. “It's kind of an ‘aha moment' because the market has priced in that central bankers mean what they say.”

The US economy has avoided recession, albeit with persistent inflation

The diverging outlook in the US and Europe was highlighted on Friday, as S&P's global purchasing managers' indices suggested that growth this month almost stalled in the euro area but continued in the US, albeit at a slower pace. The reports sparked a big rally in the European government bond market as investors turned to safe havens and US Treasuries posted smaller gains.

Still, the numbers highlighted the risk of a slowdown in global growth that would weigh on the US. And markets expect the economy to slow even if the US narrowly avoids a recession this year.

After Powell this week told US lawmakers that more rate hikes were likely, 10-year yields fell a full percentage point below 2-year yields, exacerbating the yield curve inversion normally seen as a harbinger of a recession becomes. However, this was largely due to an increase in short-term interest rates, as longer-term interest rates were little changed.

While swap traders have postponed expected rate cuts until next year, they believe the Fed's interest rate will still remain high enough to slow growth. This means that policymakers are still expected to focus on inflation rather than trying to boost growth.

Powell told the Senate Banking Committee on Thursday, “We will do whatever it takes to bring inflation down to 2% over time.” He said two more rate hikes were possible this year and that he wasn't assumes that there will be “a reduction in interest rates in the foreseeable future”.

Powell will be speaking at several global events over the coming week and may offer further insight into the political outlook.

Friday's release of the Fed's preferred inflation gauges is expected to show some improvement in May after surprisingly high readings in April, a result that would provide additional impetus for bond traders expecting more calm. Both short- and long-term consumer price inflation expectations have been stable at just above 2% since early May on the assumption that the Fed will successfully fulfill its mission.

According to economists polled by Bloomberg, the consumer spending index will slow to an annual pace of 3.8% in May from 4.4% in April. The core, which excludes food and energy, is again expected to remain at 4.7%.

“If you look at some of the inflation indicators in the US, it's clear they're falling,” Thierry Wizman, global interest rate and currency strategist at Macquarie, said on Bloomberg TV. “In the second half of the year, you will finally see the so-called stickiness that we see in “multiple inflation indexes” easing and falling. I think the market understands that.”

As the outlook has become less uncertain, volatility in the bond market has been less severe. It's also a positive sign for traders, many of whom had forecast a better year for bonds at the start of 2023, which is up about 1.6%, recovering slightly from 2022's deep losses.

The ICE BofA MOVE index, a closely watched indicator of expected swings in government bonds, has fallen by almost half since March, when it hit its highest level since 2008.

Traders now see another quarter point hike in July as likely and give another a chance. The Fed's benchmark interest rate is likely to peak at around 5.35% this year before the Federal Reserve will hike rates to around 3.8% by December 2024, a level still considered high enough to exceed that slow down economic growth.

“Given how far we've come, it may make sense to raise rates, but at a more moderate pace,” said Jared Gross, head of institutional portfolio strategy at JP Morgan Asset Management

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