Bond Market Caught Between Fears of US Debt Default, Rate Hikes
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2023-05-21 04:21
Bond traders are losing faith that the Federal Reserve is done tightening monetary policy and will ride to

Bond traders are losing faith that the Federal Reserve is done tightening monetary policy and will ride to the rescue with rate cuts this year.

The latest shift in sentiment — which during the past week put the odds of a quarter-point rate hike next month as high as 40% — will face a test in the coming week from slew of data that will gauge the strength of the economy.

Another wild card: the fitful negotiations in Washington over raising the debt limit to avoid a potentially catastrophic default as soon as next month that would almost certainly alter the Fed’s path.

The bond market in recent days has been pulled between those two poles — of a surprisingly resilient economy and a political standoff in Washington that threatens to deal it a major blow. Until Friday, when debt-ceiling negotiations hit a roadblock, traders were squarely focused on the growing risk of still-higher rates as central bank officials warned that the job of beating inflation is far from over and data showed the economy is growing at a faster-than-expected pace.

“Markets are trying to look beyond the debt ceiling and to the economy, inflation and how it influences the Fed,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “Is it a pause and then a hike again, or do they eventually cut?”

“My bias is to wait it out,” he said. “But there is a fine line between being patient and wrong.”

The dynamics are prolonging a period of unusually high uncertainty and volatility in the bond market as the Fed assesses the impact of its most aggressive interest-rate hikes in decades.

The market rallied strongly in March on speculation that bank failures would usher in several rate cuts by the end of the year. But with the turmoil in that industry subsiding, those expectations have shifted. On Friday, futures traders were pricing in roughly two quarter-point cuts by December and an approximately 25% chance of an increase at the June meeting. Two weeks earlier, the contracts were pricing in no risk of such a move next month.

“The market seems to be pricing in sort of a soft-landing scenario now,” said Daniel Mulholland, head of rates sales and trading at Crews & Associates. “So I don’t think the Fed rate cuts that had been priced in were warranted. And the Fed is talking tough” so “people aren’t surprised when they go on hold for a while.”

The strength of the economy will almost certainly take center stage if President Joe Biden’s administration and Republicans in Congress reach a deal to raise the debt limit, removing the risk of an unprecedented debt default that would roil global markets. House Speaker Kevin McCarthy indicated this week that both sides were making progress, though such optimism faded Friday as Republicans walked out of a closed-door negotiating meeting soon after it began and the discussions were put on hold.

Treasury yields have climbed to levels not seen since mid-March, with the 2-year tenor climbing as high as 4.35% on Friday — up from as low as 3.55% in late March — before paring the jump after the talks in Washington faltered. The 10-year yield reached as much as 3.72% this week, also the highest in more than two months.

The risk now for bulls is that the market would be hit by another selloff if data doesn’t soon begin to flag that the economy is slowing enough to bring down still-elevated inflation.

Moreover, with rates across Treasuries still well below the Fed’s current policy band of 5%-5.25%, even a pause in its rate hikes next month isn’t certain to ease the pressure on the market.

There’s still a debate among Fed officials on their next move, with some leaning more toward a pause and others signaling more tightening is needed to ensure inflation heads toward its 2% target. On Friday, Fed Chair Jerome Powell signaled that he’s inclined to keep rates steady next month, saying the central bank has some room to monitor the impact of its moves given the uncertainty about the economy’s trajectory.

“While a rate hike in June is possible, the Fed is more likely to ‘skip’ hiking this coming meeting with potentially one or two dissenters voting in favor of a hike,” said Derek Brown, head of fixed income at Beutel Goodman, an investment management firm. That would “allow the Fed more time to assess whether policy is sufficiently restrictive while maintaining the optionality to hike further if necessary.”

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