Bond traders are less gung-ho for Fed cuts than pricing suggests


For months on end, it has seemed like Wall Street is playing chicken with the Federal Reserve. Policymakers keep insisting interest-rate cuts aren’t coming anytime soon, yet futures traders still bet on them anyway. 

But look at options trading, says Piper Sandler’s Benson Durham, and the picture is far more complicated.

In fact, bets are piling up on a wide range of trajectories for the Fed’s path — with some expecting it to mount a major about-face as growth stalls and others hedging the risk it will tighten policy further as elevated inflation persists. Yet the most likely outcome, the trading shows, is for rates to end 2023 roughly where they will be after next week’s hike, in line with the expected trajectory laid out by central bank officials.

“What is really notable is the width of this distribution – it’s all over the place,” said Durham, who helped create the Fed’s derivative-based model when he worked as economist at the central bank. He now oversees global asset allocation at Piper Sandler in New York. “That’s what needs to be underscored, the sheer uncertainty in the market in both directions.”

The range of the trading highlights how much the cross-currents in the economy are frustrating efforts to forecast what’s ahead as the Fed edges closer to pausing its most aggressive cycle of rate hikes in decades. Analysts will be closely parsing Chair Jerome Powell’s comments after the May 3 policy decision for clues.

Some expect the speed and scale of those moves to set off a recession, one that will drive the central bank to reverse course by easing monetary policy in only a matter of months. 

Others are taking the Fed at its word, anticipating it will hold rates high until inflation pulls back toward the central bank’s 2% target — a trajectory that could choke off growth or steer the economy to a so-called soft landing. On Friday, for example, flows in Secured Overnight Financing Rate options included activity in December 2023 contracts that appeared to be targeting a Fed rate that remains higher for longer than currently priced by futures market.

The tension has fueled unusually high volatility this year. It has also left the bond and stock markets sending what appear to be conflicting signals about the outlook. Long-term Treasury yields, for example, have held below short-term ones since last year, which is usually seen as a sign that a recession is imminent. Yet at the same time, the stock market has rebounded as the economy has proved surprisingly resilient.

Overall, though, pricing in the bond and interest-rate futures market largely indicates that the Fed isn’t expected to find itself fighting against a deep contraction. 

While two-year Treasury yields tumbled sharply after the collapse of Silicon Valley Bank set off fears of a crisis last month, they’re holding near 4%, roughly where they were in September.

The Fed, which is expected to push its benchmark rate up by a quarter percentage point to a range of 5%-5.25% on May 3, has previously indicated in its forecasts that policymakers expect to hold at that level through the end of the year. But futures currently show anticipation the rate will be around 4.5% by December, indicating the central bank will ease slightly but keep it well above what’s considered neutral to growth.

“There is this idea the market has it right and the Fed has it wrong, but the reality is that the market is wrong most times on a forward basis,” said Michael de Pass, global head of linear rates at Citadel Securities. “We are meaningfully above the neutral rate — 2.5% — at the moment,” and “it is logical for the market to question why rates would remain at 5% for a length of time.”

“It’s hard to say if that’s the right choice,” he said. “From a probability point of view, the market seems overly biased toward the Fed backing down in the inflation fight.”  

Bonnie Wongtrakool, a portfolio manager at Western Asset Management, which oversees about $402 billion, said she doesn’t expect the Fed to stage such a capitulation. 

“We think the economy is in pretty decent shape,” she said. “It’s definitely our view that growth is going to decelerate and inflation is going to moderate over the course of the year. But we still think the Fed is going to be pretty patient.”

That jibes with the signals sent by the model used by Piper Sandler’s Durham. He said it indicates that the probability of the Fed easing this year is little better than a coin toss. However, the range of trading also shows moves to position for rate cuts, likely reflecting the risks posed by a standoff over the federal debt limit or additional banking-industry turmoil. 

“Even if you are right about the Fed in six months,” he said, “you are likely to bear a lot of uncertainty around that position.”

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