Bond Traders Are Reading the Federal Reserve Wrong Again
It may be a cliché, but the phrase “don’t fight the Fed” worked well for investors during the long period when the US central bank was suppressing interest rates and seeking to boost asset prices. This year, not so much.
The bond market had its worst day in almost four decades after the Federal Reserve signaled recently that it would raise its benchmark interest rate by 75 basis points, only weeks after Chair Jerome Powell convinced traders that a move of that magnitude wasn’t in the cards. Fast-forward and bonds are now rallying as recession fears fuel bets on rate cuts only a year from now! But like a couple of weeks ago, traders may be in for another costly hawkish surprise.
It’s a cycle that has played out in the bond market a few times this year, notably in March. That’s when traders took comfort in the Fed’s dovish quarter-point rate hike to roll back bets for more aggressive tightening. It was the wrong impression, and Powell said so a few days later, sparking a selloff in the bond market. It happened again this week. In testimony to Congress, Powell said for the first time that a recession may not be avoided, fueling a rally in the bond market that was later pared after he vowed that the Fed's fight against inflation is "unconditional."
But at a time when central bank forward guidance is meaningless given the uncertainty about future inflation, sticking to a familiar strategy that bad news for the economy will turn the Fed back into the market’s benefactor will prove to be a losing proposition.
It’s not that bond traders missed the signs that runaway inflation would force the Fed to tighten monetary policy more intensely than central bankers anticipated. If anything, traders have led the way for the Fed and other central banks to embark on supersized rate hikes once deemed highly unlikely. But after every tightening episode, traders have tended to revert to their old playbook, not straying too far from the guidance provided by central bankers. Even now, traders are reluctant to fight the Fed. Despite an inflation rate in excess of 8%, futures show traders are betting the target federal funds rate won’t rise much beyond 3% from the current range of 1.50% to 1.75%. That’s in line with the Fed’s guidance.