The bond market is bent on having its way and is now pricing in a Fed mistake.
In a swift reversal, the bond market began to price in more easing a day after Fed Chairman Jerome Powell surprised markets with a low commitment to future interest rate cuts and a less dovish view than expected.
Additionally, the idea that low inflation will now force the Fed to ease more than the Powell signaled after the Fed cut rates Wednesday has now filtered into the markets and is driving bond yields sharply lower and stock prices higher. The 10-year U.S. Treasury yield, which influences mortgages and other loans, fell to a stunning 1.95%, nearing a 3-year low, while the Dow surged more than 300 points.
Fed Chairman Jerome Powell upended a big chunk of market positioning yesterday when he said the Fed was in “midcycle adjustment,” not a longer running rate cutting cycle. The market had been poised for three cuts this year, and in a convulsive move, it gave back one of those cuts. But by Thursday, the odds for a September rate cut in the futures were back above 64% and traders say it’s the Fed — or at least Powell— that’s getting it wrong.
“The market was already starting to say ‘we don’t believe everything is going to be perfectly fine and this is only going to be a 25 basis point cut.’ Follow that up with weaker than expected ISM, and it’s only gaining momentum on the idea that Powell will have to ease anyway,” said John Briggs, head of strategy at NatWest Markets.
The ISM manufacturing index came in Thursday at 51.2, less than the 52 expected. It still shows expansion, but the market is sensitive to an overall trend of weakening at factories. Plus, the report came after weak manufacturing data in Europe earlier in the day. The ISM is also the last big piece of data before Friday’s July jobs report.
“If we get a weak payroll number the market might just run him [Powell] off,” said Briggs. Economists expect 164,000 nonfarm payrolls in the July report, and they expect to see wages rise by 0.2%, according to Refinitiv.
Simply put, the bond market is implying that the Fed is taking the wrong tact, and its failure to promise more easing will force it in the end to ease anyway. Traders have also taken issue with Powell’s comments from Wednesday when he said that the Fed helped the economy by just transitioning from its hawkish rate hiking cycle in December to pausing through the spring and now to easing.
Several said actions have to follow those words to prevent further market upheaval, and the comments from Powell Wednesday fell short of the commitment the market expected.
“What’s additionally worrisome is the market is pricing in an element of a policy error trade,” said Jon Hill, rate strategist at BMO.
Traders Thursday were betting against the Fed’s hawkishness, driving interest rates lower along the Treasury curve to one month lows for longer dated securities, like 10-year notes and 30-year bonds. The 2-year note yield has lost 15 basis points to 1.81%, since its high of 1.96%, hit right after Powell’s comments Wednesday. The 10-year fell to 1.96%—below 2% for the first time since July 5, after hitting a high of 2.15% on July 15. The 10-year is also edging close to a 2016 low.
Traders said bond market expectations for inflation fell Thursday, with the widely watched spread between 5-year Treasury yields and the yield on 5-year Treasury Inflation Protected Securities at about 1.5%. That is a measure of inflation compensation in the Treasury market over the next five years, including both expected inflation and a risk premium.
“The 5-year breakeven is at 1.51%. What that means is if the Fed cemented expectations at 2% that would be at 2% or even a little higher. What this indicates is the Treasury market reflecting skepticism that the Fed will be able to achieve a 2% inflation rate over the next five years,” said Hill. “In Q4, it was at 2% when the Fed was hiking. Now it’s at 1.5, and yesterday it was 1.6 [prior to Fed announcement].”
The Fed’s target for inflation is 2%, and the Fed has conceded it is concerned inflation is missing the mark. The Fed’s preferred inflation measure, the core PCE deflator is showing annualized inflation at about 1.6%.
“[Inflation expectations] They’re getting drilled because if the Fed is obstinate in easing and if it’s going to take longer than the market thinks it should take to generate inflation, they’ll underperform. Additionally, you have a stronger dollar in the wheel house so they’re getting a double whammy today,” said Briggs. “The front end of the curve, we’re going to be lower here on the week. We’re pricing rate cuts back in. It’s helping stocks and TIPS.” .
Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch, said the market’s bet against inflation longer term is also a bet that the Fed will not be there to provide support.
“Breakevens got crushed and they’re getting crushed again today. You thought at least you had some support from the Fed to help you provide some upside inflation pressure and it turns out you may not, and in that context you saw breakevens fall from the time the statement occurred,” said Cabana. “You’ve seen them fall 8 basis points in the 10-year part of the curve. I don’t think that’s what the Fed was intending to do.”
Cabana said he expects the Fed to cut rates by a quarter point in September, regardless of Powell’s comments which he described as confused and muddled.
“In the statement, the Fed said they were cutting because they were worried about global uncertainty and muted inflation. And they would continue to do that as long as those uncertainties exist because they want to sustain the expansion, ” said Cabana. “In my mind, that means the Fed is willing to do more.”
He said the Fed is focused on trade, global growth and inflation. “I don’t think any of these things are going to magically solve themselves before September,” he said.