Prepare for a "black swan"! The market began to hedge against the possibility of the Fed raising interest rates

Prepare for a "black swan"! The market began to hedge against the possibility of the Fed raising interest rates

Prepare for a "black swan"! The market began to hedge against the possibility of the Fed raising interest rates
Prepare for a "black swan"! The market began to hedge against the possibility of the Fed raising interest rates

Will the situation of the late 90s repeat itself? Even those who expect the Fed to cut interest rates are hedging against this "black swan"!

After the release of two larger-than-expected reports, the market issued a "soul torture", that is, how will the Fed deal with a US economy that will not land?

A few weeks ago, market bets on rate cuts were so prevalent that Fed Chair Jerome Powell publicly warned that policymakers were unlikely to cut rates before March.

Less than three weeks later, swap trading showed that traders not only ruled out a March rate cut by the Fed, but also considered it unlikely that the central bank would cut rates at its May meeting, and even confidence in a June rate cut was shaking.

The recent buzz in the market is that perhaps the Fed's next move will not be to cut interest rates at all. Former U.S. Treasury Secretary Summers expressed on Friday the view that many market participants are already thinking about that the Fed's next move is a "very likely" rate hike.

Even if another rate hike is unacceptable, some Fed watchers have made the view that the situation of the late '90s could be repeated, with only a brief rate cut and preparation for a subsequent hike. Earl Davis, Head of Fixed Income and Money Markets at BMO Global Asset Management, said:

"There are a lot of possible, plausible outcomes. While I insist that the Fed will cut rates by 75 basis points this year, it's hard for me to say that with confidence. ”

As far as Fed policymakers are concerned, no one has publicly said in recent weeks that further rate hikes will be made. Powell said on January 31 that "we believe our policy rate is likely to be at the peak of this tightening cycle." ”

San Francisco Fed President Daly said on Friday that a 75 basis point rate cut in 2024 was a "reasonable baseline expectation."

At the same time, the Fed has not provided "forward guidance" on the medium-term policy framework, as it has done in the past, leaving investors with a greater sense of direction. This month's volatile economic data has led to volatility in U.S. Treasuries, futures, and swaps.

Last week, US Treasury yields rose sharply after stronger-than-expected CPI and PPI data. The price increase for one of the CPI's key services was the largest in nearly two years. Job growth also beat expectations in January, although the decline in retail sales for the month contrasted with evidence that the economy continued to expand at a rate higher than its long-term potential.

Prepare for a "black swan"! The market began to hedge against the possibility of the Fed raising interest rates

Traders have recalibrated their expectations for the Fed's rate cuts

Last week, two-year, three-year and five-year Treasury yields all reached their highest levels since early December.

Lindsay Rosner, head of multi-sector fixed income at Goldman Sachs Asset Management, said:

"The final phase of this inflation battle is going to be bumpy. ”

Rosner said she agreed with Summers' assessment of the risk of rate hikes, but she believed that "it would be more reasonable to keep rates at current levels for longer" so that the Fed could ensure that inflation was contained.

Summers believes that the probability of the Fed's next rate hike could be 15%. Mark Nash, who manages absolute return macro funds at Jupiter Asset Management, believes the probability is 20%.

Even some anticipating a rate cut advocate "insuring" this possibility. BMO's Davis has been short two-year U.S. Treasuries since December, though he has covered half of his position as interest rates have climbed since the start of the year.

Kit Juckes, chief FX strategist at Société Générale, told clients in a note last week that if "the US economy re-accelerates and the Fed will eventually have to tighten monetary policy again, the dollar will rebound" and could return to all-time highs in 2022.

Analysis of short-term interest rate options by foreign media shows that after the release of CPI last Tuesday, traders began to digest the possibility of the Federal Reserve raising interest rates next year. David Robin, a strategist at TJM Institutional, said another driver of demand for anomalous options is that it's an opportunity to protect portfolios at a low cost. Robin says:

"People are trying to figure out where their portfolios are going to collapse and hedge against that. ”

Robin expects the Fed to cut rates two or three times this year.

Strategists at Citi said there should be more hedging against the risk that the Fed could have a very short easing cycle followed by a rate hike shortly thereafter. The bank's economists expect the Fed to cut interest rates for the first time in June. The bank believes that the situation of the late 90s of the last century may be repeated in the coming years.

Ira Jersey, chief interest rate strategist in the United States, said, "Just a month ago, there was no hedging of the possibility of rising interest rates, and now, at least some investors seem to be doing it." Bets that the Fed will only cut rates have diminished, but the long-tail effect remains, and this shift is important. ”

In 1998, Fed officials cut interest rates three times in a row to avert a financial crisis triggered by Russia's debt default and the near-collapse of the hedge fund Long-Term Capital Management (LTCM). Subsequently, the Fed began a cycle of interest rate hikes in June 1999 to curb inflationary pressures.

Tiffany Wilding, an economist at Pacific Investment Management, said that in addition to the volatile domestic economic data, there are also international factors. These include the Red Sea conflict and drought leading to fewer ships passing through the Panama Canal, and higher freight costs due to shipping disruptions. All of this could lead to a "stop-and-go easing" by the Fed, "where the risks are present and difficult to predict." ”

BMO's Davis said the bottom line for the interest rate market in 2024 is that "there will be extreme volatility in both directions." ”

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