Bond Traders Bet on Biggest Fed Shift in Decades on Credit Risks

(Bloomberg) — Fresh fears over a recession-inducing credit crunch are spurring bond bulls to ramp up bets that the Federal Reserve will embark on the most abrupt policy shift in almost four decades.

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Just minutes after Wednesday’s Federal Reserve interest-rate hike, traders intensified their long-standing wagers on imminent cuts as renewed turmoil in regional banks sent shivers across Wall Street. At their most anxious, markets priced in a policy about-face as soon as in July.

US employment data released Friday tempered that view, and next week’s inflation reports are expected to show scant progress toward the Fed’s 2% target. Yet key barometers of economic health, which traders have largely ignored for years, are cause for concern. The Fed’s quarterly senior loan officers survey is one. Others include a gauge of small-business sentiment and use of central-bank emergency facilities.

So while headline data suggests the US business cycle is proving more resilient than expected — keeping inflation hot and pressuring bond yields — the financial outlook may be darkening.

“If the credit tightening trend continues, it’s going to be difficult to sustain strong economic growth. Eventually, lower rates are going to be needed,” said Kathy Jones, chief fixed-income strategist at Charles Schwab & Co.

How soon is the question. A rate cut just two months after a hike would be the first time since October 1987, when then-Fed Chief Alan Greenspan slashed borrowing costs in the aftermath of Black Monday.

This time round, the Fed faces a particularly tough balancing act, with a still-resilient labor market, elevated inflation and increasing financial risks. Announcing last week’s decision to increase its target range for the federal funds rate for the tenth straight time — to 5% to 5.25% — policy makers said further increases were possible, but for the first time didn’t say they were anticipated.

While emphasizing its policy trajectory depends on incoming data, “the Fed does recognize there is clearly significant stress within the banking sector,” said Roger Hallam, global head of rates at Vanguard Asset Management. “Although a systemic crisis has been avoided, challenges are still to be resolved.”

For bond investors, it spells volatile markets, particularly in the five-year sector of the Treasury market, which is guided by expectations for the Fed policy rate in the longer term. By the end of the week, while bets on a July rate cut had mostly been washed out, rate derivatives continued to anticipate a quarter-point cut by September and a total of three by year-end.

The five-year Treasury yield moved up or down 15 basis points in a day three times this week, falling to 3.20%, its lowest level of the year, on Thursday, and ending the week at about 3.41%, displacing the 10-year note as the lowest-yielding Treasury security.

Gauges of bond-market volatility increased, without approaching the multiyear highs reached in March.

“The extremes you are seeing are intense,” Rick Rieder, chief investment officer of global fixed income at BlackRock, said on Bloomberg Television. “The only way I’ve found fruitful has been to fade the extreme.”

Rieder said he’d sold two-year Treasuries in recent days after the rally, betting that a deep recession is unlikely.

Meanwhile, the highest policy rate since 2007 is creating opportunities in short-dated obligations outside the Treasury market — which aren’t at risk from the debt-ceiling brinksmanship that helped inflate bill yields this week. Rieder said he’d bought commercial paper, short-term corporate debt, at yields near 6%, a rare opportunity over the course of his career.

All fixed-rate Treasury yields ended the week more than a percentage point below the Fed’s policy-rate threshold ahead of next week’s quarterly auctions of new 10-year notes and 30-year bonds. Those will put investor conviction in an economic slowdown to the test.

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–With assistance from Jonathan Ferro.