Bond traders dismiss Fed’s hawkish tone, bet on 2023 rate cuts

Bond investors just don’t seem to buy what the Federal Reserve is selling: that monetary-policy rates will keep moving higher and stay there for an extended period.

The policy sensitive two-year Treasury yield initially surged after the Fed’s quarterly forecasts released Wednesday showed officials expect the central bank to raise its key rate to over 5% in 2023, according to the median estimate of policy makers. That’s well above what futures traders are pricing in.

But yields soon erased their increase, even as Powell signaled the central bank still has “some ways to go” in its campaign to rein in the fastest bout of inflation since the early 1980s. Other bonds saw yields down on the day after the Fed Chair’s press conference. Yields ticked up on Thursday in Asia, with the two-year climbing two basis points to 4.23%.

The reaction likely reflects some signals in the Fed’s forecasts that point to a slowdown in growth, which may have bolstered speculation that the central bank will still wind up cutting rates next year to get the economy going again. Officials cut their 2023 growth forecasts, for example, and see an expansion of just 0.5%, and increased their prediction for the unemployment rate. The median estimate for the Fed’s policy rate in 2024 is also now around 4.1%.

The dot-plot revisions and downgrades for growth and employment are “as close to a recession call from the Fed as I can ever recall,” said George Goncalves, head of US macro strategy at MUFG Securities Americas Inc. “This is a Fed that wants to make sure the inflation job is done.”

Swaps traders expect the Fed to keep easing up on the pace of its rate hikes as it did Wednesday, when it made the widely anticipated decision to raise them by half a percentage point after four straight three-quarter point moves. The rate is now in a range of 4.25% to 4.5%.

The Fed in its statement said it anticipated further increases to make policy tight enough to pull inflation back toward its 2% target. Powell underscored that message before reporters.

“With the market already priced about a 5% cash rate in the next six months, the Fed dots are just catching up, so I am not surprised at the more muted bond market response,” said Kellie Wood, a fixed-income money manager at Schroders Plc in Sydney. “The market believes inflation will fall alongside aggressive Fed tightening.”

When asked about the rate cuts being priced into the market, Powell said Fed officials weren’t even pondering yet the idea of easing ahead.

“Our focus right now is really on moving our policy stance to one that is restrictive enough to ensure a return of inflation to our 2% goal over time,” he said. “I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2%.”

The market appears to be ignoring the Fed’s message, said Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics,

“If you look at what Powell said and what the projections were, these were hawkish remarks and hawkish projections,” he said on Bloomberg Television.