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Bond Danger Builds With Fed Set to Break From Its Cautious Past

  • Half-point rate hikes now seen at next four Fed meetings
  • Latest bout of selling deepens record losses from Treasuries

By Michael Mackenzie

The bond market, St. Louis Fed President James Bullard said on Thursday, “is not looking like a very safe place to be.” Few investors would argue with that — except, perhaps, to call it an understatement.

New waves of selling engulfed the Treasury market over the past week, roiling investors and analysts who’ve been trying to predict just how high yields will go.
On Monday, Barclays Plc threw in the towel on a little-more-than-week-old bet that the selloff had gone too far. On Wednesday, Bank of America Corp. said it looked like time to buy, a call that went awry the next day. By Friday, Federal Reserve Chair Jerome Powell’s endorsement of aggressive actions to curb inflation sent traders racing to price in half-percentage-point interest-rate increases at the bank’s next four meetings, anticipating a stark break with its decades-long practice of tightening monetary policy at a gradual pace.

“It’s a tornado right now,” said Gregory Faranello, head of U.S. rates trading and strategy for AmeriVet Securities. “Fed policy really matters now, and it’s no longer lift-off. The question is where are they going?”

Signs of investors losing their bearings are everywhere. In options on eurodollar futures, a proxy for the Fed’s rate, demand for deeply out-of-the-money structures offering protection against a series of 75-basis-point rates hikes this year cropped up. In the Treasury futures market, block trades proliferated. And Hoisington Investment Management, famous for its bullish outlook on Treasuries over the past three decades, sounded a rare note of caution in its quarterly report to clients.
The week’s volatility extended the tumultuous run for the world’s largest bond market as the Fed starts pulling back the massive monetary stimulus it unleashed soon after the onset of the pandemic. Already in 2022, Treasuries have lost over 8%, by far the worst start in the history of a Bloomberg index starting in 1973.
The selloff has been stoked by investors steadily ratcheting up expectations for the Fed’s rate hikes this year, despite a persistent rift about how far it will ultimately go.
On Thursday, Powell appeared to validate the alarmist camp when he said “front-end loading” its rate hikes may be appropriate and characterized the labor market as “unsustainably hot.”

The comments helped push yields higher. By late Friday, the two-year Treasury yield, which is highly sensitive to monetary policy changes, rose to 2.69%, up about 23 basis points from a week earlier. The 10-year yield ended at 2.9%, up 7 basis points on the week, after nearly reaching 3% on Wednesday.
Notably, Powell’s remarks and the aggressive pricing of a more rate hikes by the market failed to stop inflation expectations from rising. The 10-year measure crossed 3% en route to an all-time high.

“The Fed has lost control of inflation,” Faranello said. “Do they overtighten, or will inflation ease and help them out?”

An uncertain inflation picture and the Fed’s response has complicated efforts to forecast the longer-term outlook for the bond market.
If price increases slow, the Fed may be able to pause its hikes, resulting in a relatively low peak in the overnight lending rate, which the market sees topping out not far above the central bank’s current estimate of 2.8% by the end of next year. It’s in the range of 0.25-0.50% now. But there’s also a risk that the inflation persists — or that the Fed’s rate hikes drive the economy into a recession.

“For all the angst and volatility of recent months, the market is pricing in a similar rate tightening cycle to what we saw previously with a peak implied funds rate of 3.25%,” said Bob Miller, head of Americas fundamental fixed income at BlackRock Inc.

“What will drive the Fed and terminal pricing is the trajectory of inflation over the next six months,” he said. “That will largely determine if Fed funds reaches 2.5%, 3.5% or something higher.”

What to Watch

  • Economic calendar:
    • April 25: Chicago Fed national activity index, Dallas Fed manufacturing activity
    • April 26: Durable goods orders, FHFA house price index, S&P CoreLogic home prices, Conference Board consumer confidence, new home sales, Richmond Fed manufacturing index
    • April 27: Mortgage applications, wholesale inventories, pending home sales
    • April 28: 1Q advance GDP, jobless claims, Kansas City Fed manufacturing activity
    • April 29: Employment cost index, personal income and spending (with PCE deflator), University of Michigan sentiment and inflation expectations
  • Fed calendar:
    • No central bank speeches scheduled
  • Auction calendar:
    • April 25: 13- and 26-week bills
    • April 26: Two-year notes
    • April 27: Two-year floating-rate notes, five-year notes
    • April 28: 4- and 8-week bills, seven-year notes

— With assistance by Steve Matthews