The bond market is bent on having its way and is now pricing in a Fed mistake.
In a swift reversal, the bond market began to assume more easing is coming, a day after Fed Chairman Jerome Powell surprised markets with a low commitment to future interest rate cuts and a less dovish view than expected.
Additionally, the idea that low inflation will now force the Fed to ease more than Powell signaled after the Fed cut rates Wednesday has now filtered into the markets and is driving bond yields sharply lower and stock prices higher. The 10-year U.S. Treasury yield, which influences mortgages and other loans, fell to a stunning 1.95%, nearing a three-year low, while the Dow surged more than 300 points.
Powell upended a big chunk of market positioning when he said Wednesday the Fed was in “midcycle adjustment,” not a longer-running rate-cutting cycle. The market had been poised for three cuts this year, and in a convulsive move, it gave back one of those cuts. But by Thursday, the odds for a September rate cut in the futures were back above 64% and traders say it’s the Fed — or at least Powell— that’s getting it wrong.
“The market was already starting to say ‘we don’t believe everything is going to be perfectly fine and this is only going to be a 25 basis point cut,’” said John Briggs, head of strategy at NatWest Markets. “Follow that up with weaker than expected ISM, and it’s only gaining momentum on the idea that Powell will have to ease anyway.”
The ISM manufacturing index came in Thursday at 51.2, less than the 52 expected. It still shows expansion, but the market is sensitive to an overall trend of weakening at factories. Plus, the report came after weak manufacturing data in Europe earlier in the day. The ISM is also the last big piece of data before Friday’s July jobs report.
“If we get a weak payroll number the market might just run him [Powell] off,” said Briggs. Economists expect 164,000 nonfarm payrolls in the July report, and they expect to see wages rise by 0.2%, according to Refinitiv.
Simply put, the bond market is implying that the Fed is taking the wrong tact, and its failure to promise more easing will force it in the end to ease anyway. Traders have also taken issue with Powell’s comments from Wednesday when he said the Fed helped the economy by just transitioning from its hawkish rate-hiking cycle in December to pausing through the spring and now to easing.
Several said actions have to follow those words to prevent further market upheaval, and the comments from Powell on Wednesday fell short of the commitment the market expected.
“What’s additionally worrisome is the market is pricing in an element of a policy error trade,” said Jon Hill, rate strategist at BMO.
Traders on Thursday were betting against the Fed’s hawkishness, driving interest rates lower along the Treasury curve to one month lows for longer-dated securities, like 10-year notes and 30-year bonds. The 2-year note yield has lost 15 basis points to 1.81%, since its high of 1.96%, hit right after Powell’s comments Wednesday. The 10-year fell to 1.95% — below 2% for the first time since July 5 — after hitting a high of 2.15% on July 15. The 10-year yield, which moves opposite price, is edging close to a 2016 low, which could trigger more buying.