Treasury Traders Slash Fed-Hike Expectations as Economy Shrinks

(Bloomberg) — Treasuries rallied, dragging yields down sharply, as traders pared expectations for how much policy tightening the Federal Reserve will do based on a weak initial estimate of the US economy’s performance in the second quarter.

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Shorter-tenor securities led the way, with yields on three-year and five-year notes at one stage tumbling as much as 19 basis points, while the 10-year note’s yield was down as much as 14 basis points to 2.65%, the lowest level since mid-April. Swaps referencing Fed meeting dates now show traders expect the fed funds rate to peak around 3.25% before the end of this year, less than a percentage point above its current level.

The move follows a dive in front-end rates Wednesday in the wake of the Fed’s decision to hike by three-quarters of a percentage point, to a range of 2.25%-2.50%, and comments from Chairman Jerome Powell that appeared to be taken as dovish by the market. While some Fed watchers said the market’s reaction Wednesday was potentially wrong as they didn’t judge that Powell was signaling an imminent policy pivot, the fresh data Thursday showing two quarters of consecutive declines in gross domestic product — meeting the technical definition for a recession — gave more fuel to the slide in yields.

“The growing skepticism that the Fed will continue to deliver aggressive tightening has been emboldened” by the GDP data, said Ian Lyngen, head of US rates strategy at BMO Capital Markets.

GDP fell at a 0.9% annualized rate after a 1.6% drop in the first three months of the year, the Commerce Department’s preliminary estimate showed Thursday. Personal consumption, the biggest part of the economy, rose at a 1% pace, a deceleration from the prior period.

The yield changes steepened the Treasury yield curve, where widely watched segments including the 2- to 10-year gap and the 5- to 30-year spread inverted in recent weeks, signaling expectations the economy will weaken. The former remains inverted, at about minus 21 basis points; at one point Wednesday it reached minus 32 basis points, the deepest inversion since 2000. The 5-year to 30-year spread on Thursday touched 34.4 basis points, the steepest since mid-March.

The GDP report illustrates how inflation has undercut Americans’ purchasing power and tighter Fed monetary policy has weakened interest rate-sensitive sectors such as housing.

“There is great potential value in the short-term treasury market right now,” said Michael Wagner, co-founder of Omnia Family Wealth.

In European government debt markets, Italian bonds outperformed as money markets pared European Central Bank tightening wagers. Italy’s five-year yield tumbled 15 basis points to 3.16%, while traders are pricing less than 100 basis points of ECB hikes by year-end, the least since mid-June.

Though the US GDP data was as expected, “it will largely work to reinforce the market’s hope of a Fed policy pivot later this year,” Neil Dutta, head of US economic research at Renaissance Macro Research LLC. said in a note. “I am not so sure we get the pivot the market has in mind.”

After jumping on Wednesday, US bond-market gauges of inflation expectations fell Thursday as traders pulled back expectations for the degree of Fed policy tightening that’s likely to come.

The 5-year breakeven rate, which uses the difference between nominal and inflation-protected Treasury yields as a gauge of how fast consumer-price gains are expected to be, fell to 2.68% after reaching as high as 2.74% earlier Thursday.

Meanwhile, an auction of seven-year US debt showed buyers are more than happy to put their hand up to purchase debt right now even after the recent rally. Bidding metrics on the sale were firm and it came in at a lower yield than the rate prevailing at the bidding deadline.

“We continue to believe we are not out of the woods yet on the pressure the economy will feel from inflation and rate increases, and continue to recommend a defensive position within risk assets to weather the slowdown that is unfolding,” said Matt Peron, director of research at Janus Henderson Investors.

(Updates throughout.)

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