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A fed-funds rate that could end up as high as 6%, a level which hasn’t been seen in more than 20 years, is beginning to be seen as an outside possibility by some investors — bringing with it the risk of another painful round of selloffs in government bonds like the one seen this year.
That’s one of the potential outcomes being entertained by some in financial markets, even though it’s much too soon to say if the Fed will ever get there: Policy makers won’t deliver what’s expected to be their first aggressive rate hike of the current cycle until next week. And geopolitical, economic, or financial-market turmoil could still weaken their resolve to do more.
Nonetheless, on Tuesday, researchers at Deutsche Bank wrote that a fed-funds rate moving into the 5% to 6% range would be “sufficient to do the job” of slowing the U.S. economy and bringing down inflation, and would be bolstered by additional tightening from a smaller Fed balance sheet. They said the 10-year Treasury yield
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currently near 2.8%, could peak around 4.5% to 5%. Credit Suisse also warned in late March that the Fed’s projected rate hikes “won’t sufficiently tame” inflation.
Government bonds experienced one of their worst quarters for total returns since the Civil War during the first three months of 2022, as investors increasingly factored in less-easy Fed policy. Meanwhile, the Bloomberg’s U.S. aggregate bond index has dropped almost 10% from its peak. The 10-year Treasury rate
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soared to almost 3% last week from around 1.6% in January.
Earlier this month, the 30-year briefly broke above 3%, rising from a year-to-date low near 2%, and the 2-year yield briefly hit an intraday high above 2.8% versus 0.8% in January. All of this occurred while investors sold off bonds, pushing down their underlying prices on weakening demand.
Bond investors, unused to seeing such big drops in the prices of safe-haven Treasurys, are now preparing themselves for the potential of further pain based on how much higher the fed-funds rate — and thus, Treasury yields— could ultimately go, according to Rob Daly, director of fixed income for Glenmede Investment Management in Philadelphia.
The chart below reflects the performance of Bloomberg’s U.S. aggregate bond index, which was down by 9.8% as of Tuesday from its peak in August. Market participants use words like “very destructive” to convey the losses already experienced by bondholders.
Source: Bloomberg
“People have been expecting a moderation in economic growth and inflation,” which would end up capping the rate cycle at 2%-2.5%, said Robert Tipp, the Newark, New Jersey-based chief investment strategist and head of global bonds for PGIM Fixed Income, whose parent oversees $1.5 trillion in assets. “But really, over the last several months, some key pieces of economic data — employment in particular — have been incredibly strong. And on top of that, the inflation releases have generally been very high, and broad based, so pretty much the opposite of what most economists have expected.
“To put it in perspective, the rate of job growth and inflation over the last several months has been head and shoulders higher than where they were, say, back in 6% peak fed-funds rate cycles of 1995 and 2000,” Tipp told MarketWatch. “To the extent that the data continues to come in anywhere near current levels, that opens the possibility that markets price in an even much higher peak for the fed funds rate cycle” — something bigger than the current peak pricing of around 3%.
As of Wednesday, traders were pricing in a 46% chance of the fed-funds rate target getting to 2.75% to 3% by year-end, from its current level between 0.25% and 0.5%, according to the CME FedWatch Tool. That’s above the 1.9% year-end level penciled into the Fed’s most recent projections, released on March 16, but still in line with the projected 2.8% level seen for 2023 and 2024.
While traders are pricing in a 97% chance that the rate will go to 0.75% to 1% at the Fed’s May 3-4 meeting, they see only a 1.6% chance that it will get to 4% or higher by next July. The Fed’s long-run estimate for the rate is 2.4%.
Markets appeared to stabilize on Wednesday, as investors assessed the most likely path forward for the Fed, growth and inflation. The question is whether “there is something else going on in terms of growth and inflation that people are missing, that will make it continue to run at higher levels than expected,” according to Tipp.
To be sure, there are plenty of reasons for why the Fed might never get to a 4% to 6% policy rate. Some are geopolitical, namely Russia’s war on Ukraine and China’s COVID-19 crackdown — which might add to inflation pressures, but also hurt global growth. Another is the potential for the U.S. economy to slow either on its own or as the result of Fed hikes, as well as the chances of further financial-market volatility that makes policy makers back off.
“Everybody has been used to lower rates for so long, that what we’re trying to price in is how the Fed will combat inflation while allowing for a softish landing,” Glenmede’s Daly said via phone Wednesday. “Most of us who do this every day haven’t seen inflation like this, ever. The market is trying to put its finger on what is the most accurate reaction function by the Fed. It seems the Fed is going to have to react to fight inflation at the sake of growth, and that’s why the market has reacted as it has, specifically in fixed income.”
For now, investors are using fixed income to rebalance portfolios, which has resulted in buyers jumping back into bonds in recent days, according to Daly. This is because there is a fear that the Fed might overdo it and push the economy into recession, resulting in a safe-haven play for Treasurys, he said.
Still, the prospect of higher Fed rates from here, which would send Treasury yields another leg higher, would hurt existing bondholders the most, while benefiting potential buyers. That’s because current bondholders see the prices of their bonds drop, while potential buyers would be in a position to take advantage of those lower prices and higher yields. Treasury yields move in the opposite direction of prices, so bond selloffs drive rates higher while increased buying of Treasurys pushes yields lower.
Treasurys are “the most liquid place in all of fixed income, offering unhedged yield pickups relative to other developed countries,” said Michael Lorizio, a senior fixed income trader at Manulife Investment Management in Boston. “There’s always tremendous value in Treasurys and that’s why pricing was supported as the 10-year rate approached 3%” last week.
“In the near term, the market wants to see how the Fed’s liftoff policy affects the economy, before taking the next leg to materially higher rates,” Lorizio said via phone. Among all the scenarios being considered by investors and traders is one in which inflation, currently at its highest in more than four decades, may have already peaked and could gradually normalize on its own — making a 5% to 6% fed-funds rate “not necessary.”
“We’d have to see the fundamental structure of the economy changing on a long-term basis, and that will need to be proven over time, before we get to a 5% or 6% fed-funds rate,” he said. Still, “I do think that when you factor in all the potential outcomes, perhaps there are greater odds we’d see those levels than we imagined.”
