(Bloomberg) — Battered by the wildest swings in decades, bond investors are hungry for their next big test: navigating the Federal Reserve’s response to the mounting financial instability that threatens to derail its fight against inflation.
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Regardless of what the central bank does, investors face more pain after volatility rose to levels not seen since the financial crisis of 2008. The recent dip in Treasury yields and the sharp recalibration in Fed rate bets signal another 25 basis point hike is the most likely scenario at this stage. What really worries Wall Street now is what officials will do after that.
Dealers currently see the central bank’s benchmark ending the year around 3.8%, more than a full percentage point below the Fed’s rate estimate in the December “dot plot” that comes as part of the quarterly economic projections. It’s a dovish scenario that could hit a wall on Wednesday when the new forecasts come out.
Inflation has remained high and the labor market has shown resilience despite the most aggressive austerity 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 for interest rates going forward.
“It’s a two-way risk now, and probably even more than that,” said rates market veteran David Robin, a strategist at TJM Institutional in New York. “The only Fed move definitely off the table is a 50 basis point hike. Otherwise there are more policy probabilities and even more reaction function probabilities. It’s going to feel like forever until next Wednesday at 2pm”
Amid all the anxiety, the much-watched MOVE index, an options-based measure of expected volatility in government bonds, hit 199 points on Wednesday, after roughly doubling since late January. The yield on two-year U.S. Treasuries, normally a low-risk investment, has fluctuated between 3.71% and 4.53% this week, the widest weekly range since September 2008.
The Federal Open Market Committee will raise interest rates by a quarter of a point at the meeting on 21-22. March from the current range of 4.5%-4.75%, according to economists surveyed by Bloomberg News. Fed Chairman Jerome Powell has raised the possibility of returning to larger moves, meaning half a point or more, if warranted by economic data. But that was before concerns about the banking system sent markets tumbling.
Even with the turmoil engulfing Credit Suisse Group AG and some U.S. regional lenders, the European Central Bank moved ahead with a planned half-point hike on Thursday — but gave very few clues about what might follow.
Now the question is whether the latest banking woes will limit the Fed’s ability to tackle rate hikes that, 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 problem and it’s being solved,” said Ed Al-Hussainy, a fixed-income strategist at Columbia Threadneedle Investments. Then the Fed would be able to stick to its fight to anchor inflation and continue to tighten, he said. “It is an outcome that the market is not prepared for at this time.”
This raises the question of whether the shift lower in market prices has now gone too far.
Dot plot
Back in December, US officials predicted they would raise rates at a slow pace, with the median projection putting the benchmark at 5.1% by the end of 2023. Following Powell’s remarks to US lawmakers on March 7, bets on the new dot plot showed further tightening — with swaps traders pushing expectations for the top rate to around 5.7%.
Those bets quickly faded amid fears of a widespread banking crisis that could cause a credit crunch at a time when bets on an economic recession are running rampant. Now, swap traders are betting that Fed tightening will peak at just around 4.8% in May, with rates falling until late 2023.
Any hawkish surprise from the Fed’s point plan would deal 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 among all the uncertainties is the “tug of war” between bank contagion and inflation concerns. This is what will continue to drive sentiment in the fixed income market.
“What we don’t know is how far they tighten and what the impact is on US growth and the economy,” said Ashish Shah, chief investment officer for public investments at Goldman Sachs Asset Management. “The banks are going to set a higher threshold for lending, and this will have the effect of slowing down growth. The conclusion for investors is that they should appreciate more uncertainty in both directions for the interest rate.”
What to see
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Economic data calendar
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March 21: Philadelphia Fed manufacturing index; sale of existing homes
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March 22: MBA mortgage applications
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March 23: Jobless Claims; current account balance; Chicago Fed national activity index; sales of new homes; Kansas City Fed Manufacturing Index
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March 24: Durable goods orders; orders for capital goods; S&P Global US manufacturing and services PMIs; Kansas City Fed service activity
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Federal Reserve calendar
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Auction calendar:
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March 20: 13- and 26-week bills
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March 21: 52-week bills; 20-year bond
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March 22: 17 weeks of bills
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March 23: 4- and 8-week bills; 10-year government bonds, inflation-protected securities
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