Clarity From the Fed Is the Last Thing the Rates Market Expects

© Reuters Clarity From the Fed Is the Last Thing the Rates Market Expects

(Bloomberg) -- Perhaps the biggest surprise the Federal Reserve could deliver to the US rates market at this week’s meeting would be a clearer view of how much further borrowing costs will need to rise to restore price stability.

The outcome of the meeting, which concludes Wednesday, is widely expected to be another three-quarter-point increase in the target range for the federal funds rate, bringing it to 2.25%-2.5%. Beyond that, swap contracts referencing Fed meeting dates are pricing in a half-point increase in September and for the rate to peak at around 3.4% in December, followed by cuts in 2023.

Surprised by inflation’s failure to ebb this year, the US central bank is likely to avoid gesturing about what ultimately may be required to bring it to heel, the thinking goes. Accordingly, there’s a lot of money riding on the idea that Fed boss Jerome Powell’s need for flexibility will keep volatility measures -- derived from by the prices of interest-rate options -- elevated.

“Given all the inflation uncertainty, the Fed can’t have specific forward guidance,” said Ben Emons, global macro strategist with Medley Global Advisors LLC. “Powell has to give himself optionality.”

That expectation has driven the relative cost of hedging volatility in two-year rates, more sensitive than longer-term ones to the Fed’s policy path, to near-record levels. The price of an at-the-money one-year option on a two-year interest-rate swap exceeds the same option on a 30-year swap by the widest margin since Bloomberg started compiling the data in 2005.

The European Central Bank offered a model last week, when President Christine Lagarde formally suspended the practice of opining on future action. ECB policy makers “are much more flexible, in that we are not offering forward guidance of any kind,” she said.

High volatility has been the name of the game for months as the Fed progressed from a quarter-point rate increase in March -- its first since 2017 -- to a half-point in May and three-quarters of a point in June. At one stage this month, a full-point hike was deemed the likeliest outcome of this week’s meeting, although expectations have since been tempered.

The yield on the two-year Treasury, among the government-debt tenors closely linked to Fed policy, slid by 2 basis points to around 3% Tuesday, while the 10-year rate dropped 6 basis pints to 2.73%. The gap between those two benchmark yields, a widely watched indicator of expectations for economic growth, inverted by the most since 2000.

Any analysis of the outlook for the rates market has been complicated by mixed economic data, specifically higher-than-expected inflation combined with downside growth surprises.

“The Fed is very sensitive to inflation, and not very sensitive to growth now,” said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investments. “We don’t know if the Fed will pivot and become sensitive to growth again. Is a terminal rate of 3.5% enough to bring down inflation? My answer is that’s a very bold bet.”

Recent activity in options has lacked a discernible bias -- suggesting there’s a broad mix of expectations for Fed policy -- and open interest in short-term interest rate options is relatively balanced between bullish calls and bearish puts. That’s true for both eurodollar options, which reference the three-month London interbank offered rate, and options on SOFR, the Secured Overnight Financing Rate.

Were the Fed to appear to endorse the market’s forecast for the path of the fed funds rate, the consequences could include a purge of long-volatility structures and creation of short-volatility wagers.

“The bond market is going to keep chopping around, having likely gotten a little over excited about the Fed easing super-fast in 2023,” said Michael Cloherty, head of U.S. rates strategy at UBS Group AG (SIX:UBSG). “We need to get deeper into the year before that becomes more clear or not. And we don’t expect to get any real clarity Wednesday from the Fed on where rates are going into next year.”

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