Bond Investors Are Banking on Fed Fear of Market Chaos

  • Traders expect echo of September reference to global factors
  • Derivatives imply almost one rate increase priced in for 2016

Bond bulls are looking to the Federal Reserve’s decision Wednesday for vindication as Treasuries head for their best month in a year.

The Fed is set to release its first policy statement since it raised interest rates from near zero last month. After January’s 1.7 percent rally in Treasuries, bond bulls are watching for signs that officials expect this year’s oil-price plunge to damp inflation, or any mention of tightening financial conditions resulting from tumult in global stocks and higher-yielding debt.

Traders are banking on a repeat of September, when the central bank said “global economic and financial developments may restrain economic activity somewhat” after a surprise devaluation of China’s currency roiled global markets. The Fed stood pat in September, and Wall Street anticipates the same result when the central bank announces its decision at 2 p.m. in Washington.

“Any reference to the volatility we’ve seen in the global financial markets, and the possible slowdown in Asia, is what the market’s going to be looking for,” said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “That’ll be key.”

It’d be tough for traders to bet on an even slower pace of Fed increases, Pollack said. Futures prices show traders consider it a foregone conclusion that officials will back off the median projection for rates that they released in December. That forecast called for four increases this year, assuming they come in quarter-point steps.

Wednesday’s Trade

The benchmark 10-year Treasury yielded 2.02 percent as of 8:43 a.m. New York time Wednesday, according to Bloomberg Bond Trader data. The price of the 2.25 percent security due in November 2025 was 102 1/32.

Even before the January market turmoil, fed funds futures were pricing in just two rate increases by year-end. That’s shrunk to about one, and traders see around a one-in-four chance the Fed will raise rates at its meeting in March, data compiled by Bloomberg show.

Traders are also discounting any possibility of an unexpected jump in inflation or a surprise Fed decision on interest rates. The 10-year term premium, or the extra compensation investors demand for such risks over the next decade, has been negative all year and is close to the lowest since April, according to a Fed Bank of New York model.

Overseas Issues

“The belief is that international issues will prevent the Fed from doing the four rate hikes indicated” in December, said John Briggs, head of strategy for the Americas in Stamford, Connecticut, at RBS Securities Inc., one of the 22 primary dealers that trade with the Fed. Officials “are probably going to do as little as they can, so they don’t contribute to volatility in the market,” he said.

Financial conditions have tightened during this year’s market volatility, the Bloomberg U.S. Financial Conditions Index shows. The measure is around minus 0.3, with a negative reading indicating conditions have deteriorated relative to normal levels from before the financial crisis. It’s still above the minus 1.1 reading from August.

This month’s tumble in oil prices to a 12-year low calls into question the Fed’s assertions that consumer-price growth is on its way back to officials’ 2 percent target. The central bank’s preferred gauge of inflation hasn’t reached that level since 2012. As energy prices fell, a gauge of bond-market inflation expectations dropped as well. The 10-year break-even inflation rate, or the difference between yields on 10-year notes and inflation-linked debt, fell to its lowest since 2009 this month.

Tame Inflation

Pollack said he’s bullish on longer-maturity Treasuries relative to shorter-term securities, because he expects inflation to remain tame.

Even so, he said Treasuries may not reap any benefit if the Fed does include a reference to global financial conditions posing a risk for growth. By signaling fewer rate increases, that may boost stocks, luring money away from U.S. debt, he said.

“You could see equity markets rally on that news and fixed-income markets” decline, he said.

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