Bond Market’s Pivot Hopes Get Crushed as Powell Sees Higher Peak

(Bloomberg) — Bond investors are seeing no relief from the most aggressive Federal Reserve hiking cycle in decades. While the latest Fed statement dangled the prospect of rate hikes being downsized starting as soon as next month, chair Jerome Powell struck a hawkish tone that prompted traders to price in greater odds of policy staying high for much of next year.

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Rate-sensitive Treasuries first rallied, then got hammered, on Wednesday afternoon after Powell said “we have some ways to go” and that the ultimate level of the terminal rate may be higher than previously expected. The hint of a potential downshift in tightening saw estimates of the Fed peak in policy rates for 2023 briefly drop below 5% right after the announcement. But by the end of the session, estimates extended to a new cycle high of 5.10% for the May meeting.

In spite of the initial boost, the Fed is still seen staying the course and adjusting rates higher, particularly if the economy skirts a recession and inflation proves sticky and slow in coming down. Powell noted the resiliency of the jobs market and high inflation during his press conference and said “it is very premature” to think of pausing rate hikes.

“The bond market has priced in a higher terminal rate for 2023 and taken out more of the rate cuts that were being projected later next year,” said Mark Lindbloom, portfolio manager at Western Asset Management. “Powell took another step when he suggested the summary of economic projections next month will boost the terminal rate set by Fed officials.”

The two-year yield led the selloff across all Treasury maturities, ending the session 7 basis points higher at 4.62%. Earlier the the note’s yield fell as much as 12 basis points to 4.43% in response to a tweak in the central bank policy statement, suggesting a slower pace of tightening. The Fed on Wednesday delivered a fourth straight three-quarter point hike that lifted its policy rate to 3.75% to 4%.

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The policy sensitive two-year yield this year has reflected the most aggressive rate tightening cycle seen from the Fed in decades. After starting the year around 0.7%, the two-year yield has climbed, peaking at 4.64% last month, marking its highest level since 2007 as the Fed has boosted its policy rate from near zero.

Read more: Peak Terminal Rate Climbs Above 5% For 2023

The importance of the two-year is highlighted by how periods of consolidation such as from mid-June, helped halt a stronger US dollar and facilitated a sharp rebound for equities. Until the bearish trend in the two-year finally ends, risk assets and the dollar are seen taking their cues from the Treasury front end and the peak Fed policy rate.

“The bottom line for the market is where the terminal rate ends up and for how long it stays at that level,” said Kevin Flanagan, head of fixed-income strategy at Wisdom Tree. A funds rate of 5% next year means “the front end is mispriced and the two-year can get close to that threshold,” he said. “Powell’s message is that even if we do go only 50 basis points in December, we still have work to do. Going from 75 to 50 is only ‘Pivot Lite’.”

The recalibration of Fed tightening saw traders briefly price in around 57 basis points of tightening at the December meeting, down from 61 basis points before the Fed policy statement — it was last at 59 basis points late in New York.

“Powell is pushing back on the pivot talk, by saying it’s not about the pace of hikes, it’s level and how long they stay on hold,” said George Goncalves, head of US macro strategy at MUFG. “The market doesn’t like it, but it’s classic Powell.”

Read more: Powell Sees Higher Peak for Rates, Path to Slow Tempo of Hikes

In its statement, the Fed said the pace of additional rate hikes “will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

“The Committee is mindful of the lagged effects of monetary policy and understands that it has crammed a very large amount of tightening into a short period of time,” Michael Shaoul, chief executive officer at Marketfield Asset Management LLC. said in a note. “However, this falls short of a ‘promise to pivot’.”

–With assistance from Liz Capo McCormick and Tatiana Darie.

(Updates prices, adds comments and details throughout)

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