Bond Traders Face Dot-Plot Dilemma as Fed Seen Set on 2016 Path

  • Brexit tumult collides with predictions of unchanged dot plot
  • Higher yields a risk on Fed path showing two 2016 hikes: TD

Fed's Inflation Target: Two Percent or More?

The turbulence that’s sweeping global financial markets is warping bond traders’ ability to react to Federal Reserve signals on the path of interest rates.

Some of Wall Street’s biggest bond dealers say the Fed will stick to projections of two rate increases ahead in 2016 when it releases quarterly predictions Wednesday at the end of its two-day meeting. The firms are divided, however, on what that stance would mean for the Treasuries market, where yields are approaching record lows, partly on signs the U.S. labor market is slowing.

Strategists at BMO Capital Markets and TD Securities, among the Fed’s 23 primary dealers, say an unchanged forecast for the path of rates this year may spark Treasuries selling. They say traders would need to brace for a hike as soon as next month, a possibility that’s been practically written off in the futures market. The opposing view holds that with volatility soaring before next week’s U.K. referendum on membership in the EU, safe-haven buying will buoy bonds no matter what the Fed announces.

If policy makers maintain their projections, “it would suggest the Fed still really wants to hike twice this year, despite everything that’s happened,” said Aaron Kohli, a fixed-income strategist in New York at BMO. “The market would view it as somewhat more hawkish than expected.”

Wiped Out

Weaker-than-forecast labor data for May wiped out bets that the Fed would follow up on its year-end liftoff from near zero and raise rates Wednesday. The market-implied probability of the next increase coming this year is about 50 percent, showing traders’ skepticism that the Fed will be able to fulfill the goals it set in March.

The dot plot from that meeting -- the compilation of policy makers’ projections for where they’ll take the benchmark -- saw the Fed’s effective rate rising to 0.875 percent at year-end, compared with 0.37 percent now, signaling two quarter-point rate boosts.

If the median is unchanged for December, it would be only the second time since 2014 for that the central bank would have maintained its dot-plot projections for year-end 2016. For much of the last two years, the Fed has been dropping its targets toward expectations traders were communicating through bond prices and futures.

Brexit Pivot

Yet the threat of fresh market turbulence on a Brexit victory in the June 23 vote has some strategists looking past the latest Fed projections. Polls released Tuesday indicated the “Leave” campaign was ahead.

“Most people will turn their attention to next week’s Brexit vote fairly quickly, as it takes precedence in the global markets,” said Justin Lederer, an interest-rate strategist in New York at Cantor Fitzgerald LP, another primary dealer.

The Fed is meeting as 10-year Treasury yields approach the lowest since 2012, while Germany’s 10-year bund yield slid below zero for the first time.

“With the market currently positioned for a very dovish statement, there is some risk that rates move higher in the event of more balanced communication” from the Fed, said Gennadiy Goldberg, an interest-rate strategist in New York at TD. 

The reaction in shorter-dated Treasuries, the most sensitive to Fed expectations, would be most pronounced, said Kohli at BMO.

Some traders dismiss the September and November meetings because of their proximity to the U.S. presidential election, meaning a Fed commitment to two hikes ahead in 2016 would suggest one in July, Kohli said. That would leave the market little time to catch up to the Fed’s policy goal.

“That’s where you have to see the rubber hit the road,” Kohli said. “Will the Fed give in first, or will the market?”

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