Investors bracing for another jumbo Federal Reserve interest-rate hike are focused on a few key trades: betting on deeper inversion in the US yield curve, further losses in stocks and a stronger dollar.
Short-term Treasury rates have exceeded yields on longer maturities for months, in a time-tested harbinger of an economic downturn ahead. The MLIV Pulse survey, which drew 737 responses, showed that the bulk of contributors expect further inversion. Some see it reaching levels last seen in the early 1980s, when Paul Volcker ratcheted up borrowing costs to break the back of hyperinflation.
That outlook underscores the bearish sentiment building amid concern the central bank risks stifling growth in its fight against inflation. Most economists expect a third straight increase of 75 basis points on Wednesday, with further tightening to come. The majority of the MLIV survey’s contributors say it’s best to bet on dollar gains, and 44% prefer to sell stocks.
“The strong message from the Fed is that they want to cause demand destruction by pushing rates higher, so it's not a question of whether we go into recession but when,” said Subadra Rajappa, head of US rates strategy at Societe Generale SA. “And there’s a good chance we have a hard-landing type of situation.’’
Hotter-than-forecast consumer-inflation data last week boosted expectations for just how hawkish the Fed needs to be to curb price pressures. It pushed traders to see the Fed lifting its benchmark to a peak of around 4.5% in March, from a current target of 2.25% to 2.5% for the fed funds rate.
Inversion Bet
It’s an outlook that sets the stage for the yield curve to become more deeply inverted. Investors can make that wager by selling short-term Treasuries and simultaneously buying longer maturities. While survey respondents expect yields to rise broadly, they see shorter-tenor rates -- those most closely tied to Fed policy -- climbing more.
That’s a typical pattern when the Fed is withdrawing accommodation, and it already sent the widely watched gap between 2- and 10-year yields to minus 58 basis points last month, the most inverted since 1982. Among 446 investors expecting a deeper inversion, 62% see that gap plowing even deeper into negative territory, while 38% predict it will not go past last month’s low.
These measures bear watching because of their track record: The spread between rates on three-month bills and 10-year yields has inverted before each of the past seven US recessions.
“The bond market expects that the Fed will push rates up enough to trigger a recession," said Kathy Jones, chief fixed-income strategist at Charles Schwab.
Equity Bears
The prospect of an earnings-crushing recession combined with steeper borrowing costs delivered a decisive survey result when it comes to stocks. Futures on the S&P 500 declined on Monday, indicating another session of losses after a slump of 4.8% last week. The tech-heavy Nasdaq 100, which dropped 5.8% last week, was also heading down in Monday futures trading.
The greatest share of survey respondents, 44%, said to sell equities before the Fed meets. To be sure, the latest slump in stocks has left some investors concluding it's time to buy: 28% say buy value stocks ahead of the Fed, 16% say go long all stocks and 13% favor growth shares.