(Bloomberg) — Bond traders suspect the Federal Reserve will quickly discover it’s being too ambitious with its newly hawkish stance.
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The Federal Open Market Committee just forecast overnight rates jumping from zero currently to 1.60% and 2.10% by year-end 2023 and 2024, respectively. Traders see it differently, with eurodollar futures contracts pricing in 1.50% short-term rates on both dates.
The concern is that the economy won’t be able to handle the loftier rates policy makers have in mind, which limits how far central bankers can raise interest rates and how high Treasury yields can go.
“There is an elevated risk of a policy mistake,” said Dan Ivascyn, chief investment officer at Pacific Investment Management Co., which has $2.2 trillion of assets. “The Fed is in a difficult position.” There’s a risk “inflation stays higher for longer” than many expect, he added.
The yield on the U.S. 30-year Treasury bond has fallen to around 1.81% from this year’s peak of 2.51% in March, while the 10-year is at 1.40%. Long-term yields have come down as traders priced in the start of what they see as a quick-yet-shallow cycle of Fed rate increases. As a result, the gap between 5- and 30-year yields has plunged to 63 basis points from a multi-year high of 167 basis points in February.
Next week, the bond market will be closed on Friday in observance of Christmas, and trading will wrap up early — at 2 p.m. New York time — the day before. Assuming trading desks — ones in offices, or work-from-home ones as omicron spreads — are thinly staffed leading up to then, there could be some volatility.
“The holiday-shortened week creates the perfect environment for choppy price action exacerbated by volume and balance sheet constraints,” BMO Capital Markets strategists Ian Lyngen and Benjamin Jeffery wrote in a note.
Treasury auctions could potentially stir things up. There will be a reopening sale of 20-year bonds, which have been plagued by tepid demand. In addition, the Treasury Department will hold a reopening sale of 5-year Treasury Inflation-Protected Securities — whose yields have been on a wild ride lately as investors fiddle with their inflation projections. Treasury auctions in recent months have been a catalyst for jolts in yields.
The Bloomberg Treasury index has returned minus 2.1% for 2021, the first annual drop since 2013’s loss of 2.75%. Meanwhile, a separate Bloomberg index of Treasuries with maturities of 10 years or more has lost 4.5% this year through Dec. 16.
“The behavior of the long-end will constrain how far the Fed goes, as they will not want to risk inverting the curve,” said James McDonald, chief investment strategist at Northern Trust Investments. “One risk for investors next year is a Fed inflation pivot that results in excessive tightening of financial conditions.”
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