(Bloomberg) — Bond traders who expect gradual interest rate cuts starting in September are piling on side bets that a sudden drop in the U.S. economy could force the Federal Reserve to be even more aggressive.
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With Treasury yields rising for the third straight month, investors are fully pricing in at least two quarter-point rate cuts this year, slightly more than policymakers have signaled. In the derivatives market, some traders have gone even further, betting that central banks will be bold and deliver a half-point rate cut in mid-September, or start cutting rates sooner.
While that scenario remains marginal, speculation about the need for such a measure has grown as businesses and consumers feel the pinch from benchmark rates, which are at their highest levels in two decades. Even as inflation has eased, investors are increasingly concerned that the labor market is about to crack, something Fed officials have said they will be watching. The considerable time gap between the July policy meeting and the September one adds risk to the equation.
“It’s fair to say that if the labor market shows more signs of weakness, then the economy is in worse shape and that leads the Fed to cut rates further,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “What we don’t know is what kind of tapering cycle it will be.”
Concerns reached a new peak last week, when former New York Fed President William Dudley and Mohamed El-Erian said the Fed risked making a mistake by keeping rates too high for too long. Dudley even called for action at this week’s policy meeting. Both were writing as Bloomberg Opinion columnists.
The comment alone was enough to unsettle the market, sending policy-sensitive U.S. short-term yields into a “steepening” pattern that is typical before an easing cycle. Still, supportive data on jobless claims, U.S. growth and consumer spending helped support the central bank’s stance on monetary tightening this week.
The data “makes the Fed less anxious to act,” Michelle Girard, head of U.S. markets at Natwest, told Bloomberg Television on Thursday. “The Fed doesn’t want to appear panicked.”
Expectations of an imminent rate cut have boosted Treasury yields overall, pushing them down significantly from their late April highs, despite some recent headwinds from election concerns. The Bloomberg index of U.S. government debt hit a two-year high this month and is on track to end July on a three-month streak of gains last seen in mid-2021.
Fed officials have left their target rate at 5.25% to 5.5% for a year, waiting for signs of a sustained slowdown in inflation. With prices seemingly headed in the right direction (data released Friday showed the Fed’s preferred measure of inflation rose at a moderate pace in June), they have begun to put more emphasis on the other side of their dual mandate: full employment.
On that front, the next few months will be crucial, especially next week’s jobs report. Signs of significant weakness “could raise further questions about the soft landing and whether the Fed could be late and miss the opportunity to cut rates in July,” said George Catrambone, head of fixed income at DWS Americas.
While the Fed is widely expected to hold its ground, Fed Chairman Jerome Powell could use his Wednesday press conference to raise new economic concerns or policy changes.
If he began laying the groundwork for deeper cuts than planned, it would send a disastrous signal: It was only after the dot-com bubble burst in early 2001 and the onset of the financial crisis in September 2007 that the Fed used half-point cuts to initiate what became major easing cycles.
Michael Feroli of JPMorgan Chase & Co. doesn’t expect such a turnaround. In a note published Friday, he said he expected Powell to “avoid mentioning a specific meeting for the first cut.” As for questions about not cutting rates this month, Powell could say central banks want further evidence of progress on inflation, according to the note.
What Bloomberg Strategists Say…
“Bill Dudley’s recent column, arguing for budget cuts next week, is indicative of the change in mood. Suddenly, it’s not inflation that’s on everyone’s mind, now that the downward trajectory that was interrupted this winter has resumed. It’s the rising unemployment rate that’s front and center.”
— Edward Harrison, The Everything Risk Newsletter. Read it on MLIV.
George Goncalves, head of U.S. macroeconomic strategy at MUFG, sees more signs of weakening in the economy by September, which could prompt the Fed to respond preemptively.
“This idea of slow, gradual reductions doesn’t make sense given the data,” Goncalves said. “The longer you wait, the more you’re going to need to do more things later.”
Some market participants see enough uncertainty to warrant just-in-case bets. In recent weeks, traders have used options tied to the secured overnight lending rate, which closely tracks the Fed’s expectations for monetary policy, to position for long-term scenarios such as quarter-point moves as early as July, or a half-point cut in September.
“When a 25 basis point cut is fully priced in, you only have two options,” said Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investments. “You can go for zero or 50 basis points.”
For now, “the macroeconomic situation neither requires nor justifies” rapid easing, said Derek Tang, an economist at LH Meyer, a Washington-based monetary policy analyst firm. He said policymakers would be more likely to opt for quarter-point cuts per meeting — or 50 basis points per quarter — before attempting something as drastic as a half-point cut.
Going from a waiting period of more than a year to 50 years “means something has gone wrong and it doesn’t smell good,” Al-Hussainy said.
What to watch
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Economic data :
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July 29: Dallas Fed Manufacturing Activity
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July 30: FHFA Home Price Index; Jolts Job Openings; Conference Board Consumer Confidence and Expectations; Dallas Fed Staff Activity
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July 31: MBA mortgage applications; ADP employment; MNI Chicago PMI; pending home sales
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August 1: Challenger job cuts; initial jobless claims; nonfarm productivity; unit labor costs; S&P Global U.S. manufacturing PMI; construction spending; ISM manufacturing; Wards total vehicle sales
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August 2: US employment report for July; factory orders; durable goods orders; capital goods orders
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Fed Calendar:
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Auction Calendar:
–With assistance from Steve Matthews.
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