Fed pause in sight creates dilemma for bond investors

Investors were hit by rising yields as the Fed raised its range for interest rates

The emerging consensus that the Federal Reserve will raise rates only one or two more times has ushered in a new set of dilemmas for bond investors, who now must decide which parts of the market will fare best under the circumstances.

The US Treasury market reached an inflection point on Thursday when a report showed that consumer inflation rates declined to the lowest levels in more than a year, and Philadelphia Fed President Patrick Harker 15 minutes later said he favoured another downshift in the pace of rate increases.

Market-implied expectations for the central bank’s February meeting gravitated further towards a quarterpoint hike instead of a halfpoint, and for the first time gave small odds to the possibility of no move at all in March.

Short- and intermediateterm yields declined sharply, reaching the lowest levels in three months, while the 10year slid below 3.5 per cent, extending a rally from about 3.8 per cent at the start of the year. Plenty of uncertainty remains; earlier this week, two other Fed officials predicted an extended stay above 5 per cent for the Fed’s overnight benchmark. But investors are finally looking past the threat of higher policy rates as they set positions.

“The market has discounted all the Fed’s language about pushing the terminal rate higher than 5 per cent,” said Ed Al Hussainy, a rates strategist at Columbia Threadneedle Investments.

Having favoured long-dated bonds in recent months, he anticipates intermediate sectors will fare best on the approach to the end of the hiking cycle.

Eventually, once the Fed tells us this is the last hike — and March is a decent bet around that — then the front end is there for the taking.”

Bond investors were decimated last year by rising yields as the Fed raised its

Market-implied expectations for the central bank’s February meeting gravitated further towards a quarter-point hike instead of a half-point.

target range for overnight interest rates by more than four percentage points in response to quickening inflation.

Accumulating evidence that inflation has peaked allowed the Fed to ease up on the brakes in December with a half-point increase following four straight three-quarter-point moves. The latest slowdown in the growth rate of consumer prices in December — excluding food and energy, the fourth-quarter rate was 3.14 per cent, a 15-month low — unleashed a wave of trading.

In swap contracts referencing Fed meeting dates, the expected peak for the overnight rate declined toward 4.9 per cent. Just 29 basis points of increase are priced in for the February 1 decision — indicating a quarter-point is favoured over a half-point — and fewer than 50 basis points are priced in by March.

Market volatility

A blizzard of wagers in short-term interest-rate options after the inflation data anticipated the imminent end of Fed rate hikes and additional declines in market volatility. They included a large one expressing the view that the cycle will pause after February.

“The path of short-term rates is tied to inflation, with a swing factor around that due to how strong or weak the economy is looking,” said Jason Pride, chief investment officer of Private Wealth at Glenmede.