(Bloomberg) -- When it comes to predicting the Federal Reserve’s path, the US bond market is more misguided now than at any other time this year as traders increasingly wager the central bank will start cutting rates early next year.
That’s the view from Bloomberg Economics’ chief US economist Anna Wong and her colleagues, after Treasury bond yields retreated sharply from this year’s peaks on speculation the economy is slowing and inflation is poised to come down.
They said Friday’s release of July job-creation figures will deal a blow to the notion that the US is already in a recession by showing solid payroll growth. Tony Rodriguez, head of fixed income strategy at Nuveen, is in a similar camp: He expects significant monetary policy tightening to come in the face of persistent inflation, which will cause 2-year Treasury yields to come surging back from the recent swoon.
“The market is pricing in a Fed put,” Rodriguez said Monday on Bloomberg Television, referring to the notion that the Fed will effectively rescue markets if they fall too steeply. But we see that put’s “strike price as well out of the money,” meaning it’s far from being a profitable wager at current market levels.
“The market is being aggressive, both in terms of risk-assets’ response” and with respect to the “two-year yield,” Rodriguez said. “We think we will see an increase in the 2-year yield. And the curve will remain inverted and invert further as we move toward the end of the year.”
The 2-year note yield has plunged to around 2.89% from as high this year as 3.45% in June as speculation about a recession led traders to dial back just how high the overnight rate rate will go before the Fed has to shift gears and start easing policy to jump-start growth. Such an outlook has led to an inversion of the yield curve, with the 10-year yield at about 2.59%, some 30 basis below the two-year.
That view has also supported stocks, pushing the S&P 500 index up by more than 7% over the past two weeks, and has driven down the gap between high- and low-grade bonds, indicating that concerns about corporate distress have eased.
Swaps are pricing that the Fed’s benchmark rate will peak at about 3.3% around the end of this year and that it will start to come down in the first quarter of 2023. Earlier this year they priced the peak rate at about 4%. Last week, the Fed raised it to a range of 2.25-2.5%.
Bloomberg’s Wong and her colleagues said growth momentum is cooling. But they don’t think the US is in a recession yet, despite recent data showing the economy contracted for two straight quarters (a frequently cited technical definition of a recession). And they predict the fight against inflation is far from over: they forecast that to sufficiently rein in consumer prices, the Fed will have to lift its rate to 5% by mid-2023, with no cuts coming until January 2024.
Read more: Federal Reserve Hikes Back to Neutral, With Much More to Come
“We think the core elements of inflation are going to be stickier than market participants currently expect,” Nuveen’s Rodriguez said. “This will keep the Fed in the game longer than what’s currently priced into the futures market. That leads to an environment where fixed income returns will be challenging and volatility will be high.”