Fed Swaps Point to a Rate Cut by July, or Maybe Even June

(Bloomberg) — Bond traders eyeing the deepening rout in US regional bank shares concluded Thursday that the Federal Reserve is likely to reverse this week’s quarter-point interest-rate increase by July in response to tightening credit conditions.

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Swap contracts linked to Fed meeting dates collapsed, with the July rate briefly falling to 4.82%, a quarter point below the 5.08% level where the effective fed funds rate is likely to settle as a result of Wednesday’s increase in the target band to 5%-5.25%. Short-term Treasury yields also slumped, the five-year to the lowest level since August.

The June swap rate at lows around 5% reflected one-in-four odds of a cut as soon as June, while the December rate shed more than 30 basis points, fully pricing in an additional rate cut beyond the two that were expected at Wednesday’s close.

Short-term yields dropped for the third straight session, tracking a more than 10% plunge this week in the KBW Regional Banking Index which was driven by solvency concerns after several lender failures in March. The drop accelerated on Wednesday after the Fed statement announcing its rate decision signaled that a pause was possible in June to assess the impact of their actions to date.

“By bringing the odds of a 25 basis point rate cut into July to well over 50%, the market is essentially saying that yesterday’s hike was a mistake, in lieu of the subsequent regional bank price action,” said Alan Ruskin, chief international strategist at Deutsche Bank.

The policy-sensitive two-year yield fell as much as 15 basis points to 3.65%, down more than 50 basis points since Monday.

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The five-year Treasury note’s yield declined as much as 10 basis points to about 3.20%, a level last seen on Aug. 30. It peaked this year at 4.37% on March 8. It leaves the benchmark – seen as a barometer of the next Fed rate cut cycle – as the lowest yielding Treasury issue, with it now sitting below the 10-year, having exceeded the longer-dated note for most of the year.

“At some point there will have to be cuts because we think there will continue to be stress that could potentially lead to a meaningful slowdown in the economy,” said Harrison Choi, portfolio manager at TCW. While the pricing of rate cuts from July may well prove too early, the price action suggested “the market sees that this could get ugly and force the Fed’s hand.”

Longer-dated yields declined less and had edged higher late in New York, a sign of concern about Fed caution in the face of elevated inflation. The 30-year bond’s yield reached levels nearly 50 basis points higher than the five-year note’s yield, compared with 17 basis points earlier this week.

“With the Fed on hold and inflation still high, some additional term premium may be warranted in longer-term Treasury securities,” said Roger Hallam, global head of rates at Vanguard Asset Management.

The bond market rally and growing conviction of rate cuts this year, is set for a test with the arrival of the US employment report Friday. Treasury yields backed up from their session lows and the extent of rate cut bets ahd eased a touch late in New York, Thursday.

A gain of 185,000 payrolls in April versus a prior rise of 236,000 is forecast according to a Bloomberg survey of economists. Wages are estimated to expand unchanged at a 4.2% annual pace.

Any selloff on firmer data, with April inflation due next week, likely finds buyers given the concerns over bank credit. The Fed will release its senior loan officer survey next Monday and that is expected to show a further tightening of bank lending.

Choi said TCW is “not fading the front end move but are buyers on back ups,” and he added “our approach has been to dollar cost average into steepeners with long bets at the front end of the curve everytime yields rise there.”

–With assistance from Edward Bolingbroke and Benjamin Purvis.

(Adds quotes, updated figures.)

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