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Bond traders are quickly lowering their expectations for how high the Federal Reserve will push the borrowing costs — while also once again fully pricing in a rate cut from the peak level by year-end — as banking sector concerns mount.
Pricing on swaps linked to Fed meetings moved on Friday to suggest traders now expect that the central bank’s policy rate will peak at around 5.4% in July, but end the year around 5.1% — more than a quarter point lower. The target range was raised to 4.5%-4.75% on Feb. 1.
As recently as Wednesday, the expected peak was around 5.7% in September, a reaction to Fed Chair Jerome Powell seeming to open the door to a re-acceleration in the pace of rate hikes in congressional testimony the previous day. The subsequent collapse of SVB Financial, a Santa Clara, California-based bank holding company, sparked a reckoning.
Fed officials “do have to pay attention to this because something is apparently starting to break, and they have raised rates a lot,” said Tony Farren, managing director at Mischler Financial Group Inc. “The reaction to Powell was way too aggressive.”
Meanwhile, the two-year Treasury yield was on track for its second-straight day with moves lower of more than 20 basis points. That yield fell as much as 29 basis points to 4.58%. Its current 36-basis-point drop over two days is bigger than any since 2008.
In the fallout from Powell’s comment, the two-year yield climbed to 5.08% on Wednesday, the highest level since 2007, setting the stage for a snap-back as bets on a deeper selloff accumulated.
The spark occurred Thursday, when SVB Financial blamed higher interest rates as it took unsuccessful steps to shore up capital, on Friday becoming the first federally insured institution to fail this year. To varying degrees, shareholders punished the entire banking sector. Financial companies in the S&P 500 are down about 7% as a group on the week, leading the benchmark to a 3.4% drop.
“It appears that the fear of a hard landing is starting to be built back into rate expectations,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management. “Bank stress may be seen as a sign that monetary policy is working to tighten conditions, albeit with a lag.”
Longer-dated Treasury yields also declined by at least 10 basis points Friday, aided by mixed February employment data seen as lessening the need for the Fed to re-accelerate.
Swap traders now see a 25-basis point hike at the March 22 policy meeting as more likely than half-point move, which was given odds as high as about 75% earlier in the week.
With short-term yields leading the declines, the Treasury curve steepened. At 4.72%, two-year yields were 96 basis points higher than 10-year rates. The gap between the two exceeded 100 basis points earlier this week for the first time since 1981.
