Great Recession trading in the treasury market is gaining momentum

(Bloomberg) — The bond market is heading into a recession in the United States next year, as traders bet that the longer-term path to interest rates will fall even as the Federal Reserve is still busy raising its policy rate.

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Long-term Treasury yields are already below the Fed’s benchmark range – currently 3.75% to 4% – and there is still an extra percentage point of central bank rate hikes for the coming months. There has also been activity in the options market indicating that some are hedging against the risk that policy prices may eventually fall in half from their current level.

Instead of waiting for definitive economic evidence that frantic monetary tightening this year will lead to recessionary conditions in 2023, investors have been buying bonds — a position endorsed, among others, by Pacific Investment Management.

“The Fed’s policy is dynamic and they’re still signaling that they’re going to go higher,” said Gregory Varanello, head of US interest rate trading and strategy at AmeriVet Securities. “But the market is trading like it’s more comfortable with the Fed getting into the end game.”

Demand for longer-term Treasury notes this week pulled the 10- and 30-year bond price below the lower end of the Fed’s overnight range. With final interest rates relatively flat, this has seen an intensification of the most pronounced yield curve inversion in four decades – a widely watched indicator of potential economic pain to come.

“The recession indicator narrative is strong, but from the Fed’s point of view it is part of the solution,” Varanello said.

The US economy – and especially the labor market – has so far shown itself to be very resilient in the face of Fed interest rate increases, which are intended to try to curb high and what appears to be persistent inflation. Thus, investors will be very familiar with the monthly jobs report next Friday looking for signs of a crash, or indications as to whether it might pave the way for the Federal Reserve to adjust its policy course.

They will carefully scrutinize the words of Fed Chair Jerome Powell and his colleagues, who next week will speak publicly for the last time before heading into their usual obfuscation period ahead of the Fed’s Dec. 13-14 policy meeting. While the minutes of their latest meeting showed that they will likely slow the pace of tightening soon, officials have been firm in reaffirming the need for interest rates to move above current levels.

At this point in the cycle, the Fed may prove less effective than tone the data, given expectations for a gradual deceleration of policy tightening from here amid conviction that inflation has peaked and job creation is slowing.

The measure of the upside in the long end of the bond market right now – and the depth of the yield curve inversion – means there could be some turmoil in Treasurys as traders navigate a batch of higher-level data next week, not just the jobs report. Recessionary bets could find support from an expected contraction in the ISM manufacturing measure, while the Personal Income and Spending report will show how things are developing on personal consumption spending, the Fed’s preferred measure of inflation. Figures on the number of vacancies are also due to be released.

Current swap market pricing shows the effective federal funds rate rising to about 5% by the middle of next year, followed by a dip falling more than half a percentage point by early 2024. But some are betting on a much sharper reversal, with this week’s trading tied to contracts. Guaranteed overnight financing rate futures that focus on the possibility of a decline to 3% or even 2% by the end of 2023 or early 2024.

However, there is resistance in some quarters to the current bond market consensus around the Fed, the economy and of course an eventual return to low inflation next year. Goldman Sachs Group Inc. said: This week the 10-year trade will exceed 4% through 2024 as expectations of a rate cut next year have faded as the economy has not entered a recession and inflation remains high.

This is far from the central view though. Market prices suggest that even if the Fed itself is not yet central to policy, many investors are increasingly turning away from the risks of relentless Fed hikes and toward a possible economic recession.

what do you want to watch

  • Economic calendar:

    • November 28: Dallas Federal Reserve Bank’s Industrial Activity Index

    • November 29: Conference Board Consumer Confidence. FHFA House Price Index

    • November 30: ADP Hiring; MBA Mortgage Applications. GDP for the third quarter; the progress of the trade balance of goods; Wholesale and retail inventory. MNI Chicago PMI; pending home sales; JOLTS job opportunities; Fed Beige Book

    • December 1: Report personal income and expenditure, including personal consumption expenditures; ISM Manufacturing Weekly Unemployment Claims

    • December 02: Monthly Jobs Report

  • Federal Reserve Calendar:

    • November 28: John Williams of the Federal Reserve Bank of New York. James Pollard from St. Louis vid

    • November 30: President Jerome Powell. Judges Lisa Cook and Michelle Bowman

    • December 01: Vice President for Oversight Michael Barr; Lori Logan of the Federal Reserve Bank of Dallas; Bowman

    • Dec 02: Charles Evans of the Federal Reserve Bank of Chicago

  • Auction calendar:

    • November 28: Bills 13 weeks and 26 weeks

    • November 29: 52 weeks billing

    • November 30: 17-week billing

    • December 1: 4-week and 8-week bills

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