Treasuries Unlikely To Sell Off Even On Hawkish Fed

By Ven Ram, Bloomberg Markets Live reporter and strategist

The intensity of the selloff in Treasuries may have peaked before this week’s meeting of the Federal Reserve. That means any further increase in yields is likely to be measured, while a dovish dot plot would provoke a tactical short-term rally.

Front-end Treasuries declined the most in almost a year last week, with yields on the two-year maturity soaring by 25 basis points to almost 4.73%. At that level, it wasn’t far from pricing in just two Fed interest rate cuts this year.

Should the Fed’s new dot plot indicate a hawkish pivot, yields could climb to 4.82%, less than 10 basis points higher than the closing level on Monday. While it is possible that yields may jump more in a knee-jerk reaction, that won’t be sustainable.

However, should the dot plot stay unchanged for this year — that is, the Fed retains its December projection of three rate cuts — that would spur the markets to price in the possibility of even more loosening, as they have been for much of this year.

Such a prospect would send two-year yields lower by some 20 basis points from their close on Monday to 4.54%, based on correlations with Fed funds futures.

During the December meeting, as many as eight Fed officials thought that rate cuts in 2024 would amount to 50 basis points or less. So the bar for the median to shift to just two reductions isn’t high.

The case for a hawkish turn may come from inflation: since that dot plot, headline inflation has continued to stay above 3%, while core inflation has been trending close to 4%.

Consequently, several Fed speakers have pushed back on market pricing for imminent rate cuts. Fed Atlanta President Raphael Bostic remarked recently that markets shouldn’t expect back-to-back rate cuts since the central bank is concerned that a new wave of demand could reignite inflation.

Chair Jerome Powell has, however, been more conciliatory, commenting that the Fed isn’t far from the level of confidence needed to loosen policy. That would be an argument for the Fed to stay with its current dot plot.

Meanwhile, the stickiness of recent inflation prints has spurred a debate on the neutral rate, a nirvana state that would prevail when the economy is at full employment and inflation steady. The Laubach-Williams model estimates that the rate is now around 1.12%, compared with the Fed’s dot plot that has traditionally assumed a rate of just 50 basis points. Given that contrast, the spotlight would be on any revision to its estimate of the longer-run interest rate.

All told, Treasuries are now approaching a crossroads, and there is a fair bit of asymmetry in the way they could go in the aftermath of the Fed review.