Fed Hike No Longer Certain for Traders as Bank Woes Spur Bonds

(Bloomberg) — Bond traders are no longer fully convinced that the Federal Reserve will do one more quarter-point interest-rate hike.

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Short-end market rates tumbled Tuesday as a renewed slide in US regional bank shares sent Treasuries surging as investors scurried toward haven assets.

Swap contracts for June are now pricing in a central bank benchmark just 21 basis points above the current effective fed funds rate, implying around a four-in-five chance of a hike at one of the next two policy meetings. They had previously this week been pricing May as a near certainty and some possibility of an additional increase in June.

“The bond market is responding to the regional bank news,” said Michael Cudzil, a senior portfolio manager at Pacific Investment Management Co. “It is too soon to call this a crisis,” but there is concern around more banks coming under pressure and unwinding their holdings, he said.

The policy sensitive two-year Treasury yield slid as much as 18.7 basis points, the biggest intraday drop in about a month, to as low as 3.90%. The move came as the KBW regional bank index fell as much as 4% to a new low for the year.

Shares in troubled California-based lender First Republic Bank were halted after the stock price plunged, with the company said to be exploring divesting $50 billion to $100 billion of long-dated mortgages and securities as part of a broader rescue plan.

The rally in Treasuries gained momentum after the sale of $42 billion two-year notes was absorbed below 4% at 1pm in New York and came as traders tempered expectations ahead of next week’s Federal Reserve meeting.

In addition to slashing the odds of tighter policy, swaps also showed an increase in the amount of post-peak central easing being priced in, with the benchmark seen around 4.3% by year end. The effective fed funds rate is currently 4.83%.

Wells Fargo strategists Angelo Manolatos and Mike Schumacher wrote in a note to clients that they doubt the Fed will allow current banking sector angst to deter the central bank from hiking again and that the market might struggle to dial back its bets on near-term tightening much further.

This Friday’s income and spending report, which includes the personal consumption expenditure measure that the Fed looks closely at, is likely to be a key focus for traders ahead of next week’s decision. But the bar appears high for it to budge the central bank from the course it hinted at before officials went into their pre-meeting communications blackout.

“It would take a pretty large shock” on PCE for the Fed to not hike next Wednesday, said RJ O’Brien & Associates Managing Director John Brady. “It seems a bit early to hit the panic button.”

–With assistance from Edward Bolingbroke.

(Updates with extra comments.)