(Bloomberg) – Bond investors battered by the wildest swings in decades are gearing up for 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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Whatever the central bank does, investors face more difficulty after volatility soars to levels not seen since the 2008 financial crisis. The Fed is signaling that another 25 basis point hike is the most likely scenario at this point. Now, what really worries Wall Street is what officials will do after this.
Traders currently see the central bank’s benchmark index ending the year around 3.8%, more than a full percentage point below the Fed’s rate estimate in the dot plot. of December which is part of the quarterly economic projections. It’s a dovish scenario that could hit a wall on Wednesday when the new forecast comes out.
Inflation has remained high and the labor market has shown resilience despite the most aggressive tightening campaign in decades. Whether the Fed chooses to stay focused on that or prioritize concerns about the health of the financial system could determine the path forward for rates.
“It’s a two-way risk now, and probably even more than that,” said rates market veteran David Robin, strategist at TJM Institutional in New York. “The only Fed move that is definitely out of order is a 50 basis point hike. Otherwise, there are multiple policy probabilities and even more reaction function probabilities. It’s going to feel like an eternity until Wednesday. next at 2 p.m.
Amid all the angst, the widely watched MOVE index, an options-based measure of expected Treasury bill volatility, hit 199 points on Wednesday, after roughly doubling since late January. The yield on two-year U.S. bonds, normally a low-risk investment, hovered between 3.71% and 4.53% this week, the widest weekly range since September 2008.
The Federal Open Market Committee will raise rates a quarter point at its March 21-22 meeting from the current range of 4.5% to 4.75%, according to economists polled by Bloomberg News. Fed Chairman Jerome Powell has raised the possibility of returning to larger moves, meaning half a point or more, if economic data warrants. But that was before worries about the banking system rattled markets.
Even with the turmoil that has engulfed Credit Suisse Group AG and some U.S. regional lenders, the European Central Bank on Thursday announced an expected half-point hike, but offered very few clues as to what might come next.
Now the question is whether the recent banking problems will limit the Fed’s ability to tackle price gains which, while moderating, remain well above the 2% target.
“The most painful outcome would be a Fed coming in and saying we have this financial stability issue, and it’s being resolved,” said Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investments. Then the Fed could continue its battle to anchor inflation and continue tightening, he said. “It’s an outcome the market is not prepared for at this stage.”
This raises the question of whether the decline in market prices has now gone too far.
In December, U.S. officials forecast they would raise rates at a slow pace, with the median projection putting the benchmark at 5.1% at the end of 2023. After Powell’s remarks to U.S. lawmakers on March 7, bets for the new dot chart showed tightening – with swap traders pushing expectations for the maximum rate to around 5.7%.
Those bets quickly crumbled amid fears of a widespread banking crisis that could trigger a credit crunch at a time when bets on an economic downturn run rampant. Now, swap traders are betting that Fed tightening will peak at around 4.8% in May, with rates falling through the end of 2023.
Any hawkish surprise from the Fed’s point plot would be a blow to 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 sure thing amidst all the uncertainty is the “standoff” between banking contagion and inflationary concerns. This is what will continue to drive sentiment in the rates market.
“What we don’t know is how much they are tightening and what the impact is on US growth and the economy,” said Ashish Shah, director of public investments at Goldman Sachs Asset Management. “Banks will set a higher threshold for lending and that will have the effect of slowing growth. The conclusion for investors is that they should factor in greater two-way uncertainty for interest rates.
What to watch
Economic Data Calendar
March 21: Philadelphia Fed manufacturing index; Sales of existing houses
March 22: MBA Mortgage Applications
March 23: Unemployment insurance claims; current account balance; Chicago Fed National Activity Index; sales of new homes; Kansas City Fed Manufacturing Index
March 24: Durable Goods Orders; orders for capital goods; S&P Global US Manufacturing and Services PMI; Kansas City Fed Services Activity
Federal Reserve calendar
March 20: 13 and 26 week invoices
March 21: 52-week bills; 20 year bond
March 22: 17-week bills
March 23: 4 and 8 week invoices; 10-Year Treasury Inflation-Protected Securities
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