(Bloomberg) — The bond market is finally in sync with Jerome Powell’s forecast for the economy.
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Traders canceled previously aggressive bets that the Fed chief could focus on easing policy before the end of this year, reflecting sharply diminished expectations that a central bank rate hike would trigger a severe recession. Bond yields have returned to levels seen before the panic sown by the Silicon Valley bank collapse.
Even as policymakers see an opportunity to raise interest rates twice more in the coming months, the US economy is poised to hold up well, in contrast to Europe, which is showing signs of slowing.
“There is a realization that the Fed will not cut interest rates this year,” said Greg Peters, chief investment officer at PGIM Fixed Income. “It’s kind of a market-priced ‘ah-ha’ moment that central bankers mean what they say.”
The US economy avoided a recession but with sticky inflation
Diverging expectations in the US and Europe were underlined on Friday, when global purchasing managers’ indices from Standard & Poor’s indicated that growth had nearly stalled in the eurozone this month but had picked up in the US, albeit at a slower pace. The reports fueled a rally in the European government bond market as investors turned to havens, with US Treasuries posting smaller gains.
However, the numbers highlighted the risk of a slowdown in global growth that would weigh heavily on the United States. Markets were expecting the economy to slow, even if the US narrowly avoided a recession this year.
After Powell told US lawmakers this week that interest rate increases were likely, 10-year yields fell to a full percentage point below two-year rates, deepening the yield curve inversion usually seen as a harbinger of a recession. But this was largely due to an upward surge in short-term rates as longer-term rates were unchanged.
While swaps traders have pushed expected cuts into next year, they expect the Fed’s key interest rate to remain high enough to dampen growth. This means that policymakers are still expected to focus on inflation, rather than trying to drive growth.
“We will do what it takes to bring inflation down to 2% over time,” Powell told the Senate Banking Committee. He said rates could have been raised two more times this year and he didn’t see a drop in rates “happening any time soon”.
Powell will be speaking at several global events this week, which could give more insights into the policy outlook.
The release of the Fed’s preferred inflation gauge on Friday is expected to show some improvement in May after surprisingly hot readings from April, a result that should add additional impetus to bond traders who see more calm ahead. Indeed, short- and long-term consumer price inflation expectations have held steady at just over 2% since early May amid expectations that the Fed will succeed in its mission.
The personal consumption expenditures index is expected to slow to an annual pace of 3.8% in May from 4.4% in April, according to economists polled by Bloomberg. The core measure, which excludes food and energy, is expected to hold steady again at 4.7%.
“If you look at some of the indicators of inflation in the US, it’s clearly declining,” Thierry Weizmann, global interest rate analyst and currency strategist at Macquarie, said on Bloomberg TV. “In the second half of the year, you will finally notice that the so-called sticking that we see in ‘many inflation indicators’ start to loosen and come down. I think the market understands that.”
With increasing uncertainty in the future outlook, the volatility in the bond market has been less extreme. This is also a positive sign for traders, many of whom have come into 2023 anticipating a better year for bonds, which gained about 1.6%, rebounding slightly from deep losses in 2022.
The ICE BofA MOVE Index, a closely watched proxy for expected treasury volatility, has fallen by nearly half since March, when it reached its highest level since 2008.
Traders see another quarter-point rally in July now as likely to give another chance. The Fed’s policy rate is expected to peak this year at around 5.35% before the US central bank pushes interest rates to around 3.8% by December 2024, a level still considered high enough to slow economic growth.
“Given how far we’ve come, it might make sense to raise interest rates but do so at a more moderate pace,” said Jared Gross, head of institutional portfolio strategy at JP Morgan Asset Management.
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