Bond traders got all the ammo they needed from slower-than-forecast US consumer price growth to fully lock in a Federal Reserve downshift in monetary tightening, but annual inflation of 7.1 percent still looks too high for policymakers to start thinking about reversing interest-rate hikes.
The rally in Treasuries that took off after Tuesday’s inflation data runs the risk of stopping short as investors start paring back some of the most bullish bets on how soon the Fed will start easing.
The November CPI report triggered swaps traders to lay out a more tempered trajectory, putting the peak Fed policy rate in this cycle below 5 percent. While that implied a notch down to a 50-basis-point hike from the Fed at its meeting Wednesday and smaller increases thereafter, investors warn policymakers will push back against some of the most optimistic pricing for rate cuts next year.
“The Fed has ample room to decelerate the pace of hikes,” said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. “It gives them room to stop hiking early next year but they are still going to want to send the message that they are going to want to hold rates — as opposed to signaling cuts that the market’s got priced in.”
The US five-year yields tumbled as much as 24 basis points on Tuesday to 3.55 percent, the lowest level since September 13, before rebounding to close at 3.65 percent. The yield was little changed on Wednesday in Asia. Longer-maturity yields declined less, causing the Treasury curve to become less inverted. Any steepening of the curve may be tempered should the Fed indicate it will remain vigilant on inflation and maintain a hiking stance, albeit at a slower pace.
Fed Chairman Jerome Powell said last month officials’ new estimates on the trajectory of policy, which will be announced Wednesday, will show a higher path for the funds rate. He also has said rates will have to stay high for some time even as the bond market has priced in rate cuts for the second half of next year and into 2024.
The median Fed official forecast in September put the funds rate at 4.4 percent for year-end and 4.6 percent a year later, with some economists forecasting the 2023 median rate to rise as high as 5.1 percent. November’s CPI figure has rates markets seeing a better probability that it is moved up only to 4.875 percent, according to Blake Gwinn, head of US rates strategy at RBC Capital Markets.
The inflation numbers drove swaps traders to price in a peak of around 4.86 percent for the Fed’s policy rate in May, down from around 4.99 percent before the release and from well over 5 percent a few months ago. By December 2023, traders see the Fed pushing the funds rate down to around 4.36 percent — representing about a half-point of policy easing by the end of 2023.
Fading Bias
Still, there’s a sense among bond investors that the recent recovery in Treasuries has run too far as the outlook for the economy and inflation remains uncertain.
“Our bias is to fade this rally and look to how people position in early January,” said John Madziyire, a fund manager at Vanguard Group Inc. “The return of inflows for bond funds means there has been more comfort in adding duration,” with the ensuing rally in Treasuries gaining speed from bearish investors “closing out trades into year end,” he said.
Unusually, the decline in yields began about a minute before the Labor Department’s release of November CPI data at 8:30am in Washington, and continued thereafter. The monthly increase in CPI slowed, indicating inflation is receding in the face of the Fed’s most aggressive monetary policy tightening in decades.
“Investors should be careful not to over-extrapolate these results and temper their expectations for a premature pivot from the Fed,” Jason Pride, chief investment officer of Private Wealth at Glenmede wrote in a note. “Consumer inflation is still far from the Fed’s price stability goals, and the 1970s provide case-in-point as to the risks of claiming victory on inflation too early. The Fed will likely need to keep monetary policy on a restrictive footing into the new year.”
Share prices also pared gains on Tuesday with the Fed path in focus. The asset classes losses combined with those in bonds has caused investors in the popular 60/40 split between equities and high-quality bonds to lose around 15 percent this year, according to a Bloomberg index.
The slide in rates since the end of October has netted bond holders gains in November of about 2.7 percent and helped offset what has been a historic year of losses. The Bloomberg US Treasury index has fallen about 11 percent this year through Tuesday.
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