Traders have no doubt that the Federal Reserve will keep raising interest rates over the next few months. It’s when and where the central bank stops that’s proving far more vexing.
Even with inflation at a four-decade high, the swaps market is still pricing in a steep but shallow cycle of interest-rate hikes, one that will leave the overnight benchmark not too far above the 2.5% peak at the end of the Fed’s last tightening cycle in 2018. In the mid-1990s, it hit 6%. It reached 20% in 1980.
That unusually low end point expected this time around is puzzling investors seeking to properly position for the Fed’s cycle, fueling unusually strong about-faces in the Treasury market. That was evident last week: Yields tumbled Wednesday after Fed Chair Jerome Powell waved off expectation the bank will increase the size of its rate hikes, only to surge back Thursday and Friday on fears the Fed may find itself facing a prolonged battle against inflation that could stall economic growth.
Powell underscored the uncertainty Wednesday when asked to pinpoint where the rate needs to be to neither slow nor fuel growth, saying “there’s not a bright line drawn on the road that tells us when we get there.”
“You can’t really quantify how far they go,” said Alan Ruskin, chief international strategist at Deutsche Bank AG, who predicts that elevated volatility will persist. “It’s a cycle at its core that is very different to what we have seen for a very long time, with inflation so high and a Fed well behind the curve.”
Positioning in the rate futures markets shows that traders expect the Fed’s benchmark to rise to 3.3% by mid-2023 from a range of 0.75%-1% now. But such contracts show hefty wagers that the central bank will start easing monetary policy again in early 2024 to spur the economy forward.
The potentially conflicting cross currents are adding to the high uncertainty that’s fueling market volatility. With the U.S. consumer price index Wednesday expected to show another annual increase of more than 8%, job growth strong and the unemployment rate near a more than half-century low, it’s far from clear whether the Fed can slow growth without setting off a recession.
“Yields will move higher until something breaks, either the economy or inflation,” said Jack McIntyre, a portfolio manager from Brandywine Global, who has been limiting exposure to Treasuries, watching for a time to buy once tighter financial conditions show signs of slowing the economy.
The risk posed to economic growth has driven an increase in wagers that the difference between short- and long-term yields will narrow or turn negative as growth stalls.
That was a winning bet for most of the year as the yield curve flattened steadily. Key segments inverted early last month following the steep jump in short-term yields as the Fed kicked off its rate hikes in March.
But even that has since proved no sure thing as the resurgence of inflation rips up the playbook of recent decades. Longer-term bond yields jumped the most during the renewed selling last week after Powell waved off speculation it would raise rates by 75 basis points at upcoming meetings. That renewed concerns the bank isn’t moving fast enough, raising the specter of stagnant growth with still-elevated inflation.