Bond Traders Are Reading the Federal Reserve Wrong Again

(Bloomberg Opinion) -- It may be a cliché, but the phrase “don’t fight the Fed” worked well for investors during the long period when the US central bank was suppressing interest rates and seeking to boost asset prices. This year, not so much.

The bond market had its worst day in almost four decades after the Federal Reserve signaled recently that it would raise its benchmark interest rate by 75 basis points, only weeks after Chair Jerome Powell convinced traders  that a move of that magnitude wasn’t in the cards. Fast-forward and bonds are now rallying as recession fears fuel bets on rate cuts only a year from now! But like a couple of weeks ago, traders may be in for another costly hawkish surprise.

It’s a cycle that has played out in the bond market a few times this year, notably in March. That’s when traders took comfort in the Fed’s dovish quarter-point rate hike to roll back bets for more aggressive tightening. It was the wrong impression, and Powell said so a few days later, sparking a selloff in the bond market. It happened again this week. In testimony to Congress, Powell said for the first time that a recession may not be avoided, fueling a rally in the bond market that was later pared after he vowed that the Fed's fight against inflation is "unconditional."

But at a time when central bank forward guidance is meaningless given the uncertainty about future inflation, sticking to a familiar strategy that bad news for the economy will turn the Fed back into the market’s benefactor will prove to be a losing proposition.

It’s not that bond traders missed the signs that runaway inflation would force the Fed to tighten monetary policy more intensely than central bankers anticipated. If anything, traders have led the way for the Fed and other central banks to embark on supersized rate hikes once deemed highly unlikely. But after every tightening episode, traders have tended to revert to their old playbook, not straying too far from the guidance provided by central bankers. Even now, traders are reluctant to fight the Fed. Despite an inflation rate in excess of 8%, futures show traders are betting the target federal funds rate won’t rise much beyond 3% from the current range of 1.50% to 1.75%. That’s in line with the Fed’s guidance.

It’s a similar situation outside the US. Until last week’s blowout in euro-area government bond spreads, traders there had also been reluctant to price in a more hawkish European Central Bank even in the face of the highest inflation rate in more than 40 years. In Japan, only a minority of contrarian funds are daring to question whether the Bank of Japan will abandon its yield-curve control policy.

What traders seem slow to accept is that markets have entered a new regime, and inflation is no longer a benign force in the background. The old playbook of well-telegraphed and gradual central bank moves guiding the markets gently toward a predetermined goal post won’t work when the goal post keeps shifting. My Bloomberg News colleague at Markets Live Ven Ram provided a good estimate of just how much the goal post has shifted, based on the Fed’s own rules. Powell said that by the end of the year, the Fed’s policy rate “will be pretty close to where some of the Taylor Rule iterations are.” That’s 4.93% based on current estimates, or more than 3 percentage points above the current fed funds rate. The market is only pricing another 1.75 percentage points of rate increases between now and December. The Fed’s “dot plot” shows even less tightening.

So, while traders rush to hedge for a recession that has yet to arrive, they forget that the fight against inflation is far from over. The next bond market selloff is no more than another bad inflation report away. Perhaps it’s time for traders to fight the Fed.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jenny Paris is executive editor at Bloomberg News for global bond, currency and emerging markets. She has previously worked at the Wall Street Journal and Dow Jones Newswires covering the euro zone crisis and as a managing editor for Asia equity markets.

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