Brexit Shock Erased for Treasuries as Fed Rate Bets Make U-Turn

  • Futures traders rebuild wagers on interest-rate hike in 2016
  • Policy makers to meet for first time since U.K. referendum

To the federal fund futures market, it’s like Brexit never happened.

The implied probability that the Federal Reserve will raise interest rates by year-end touched 47 percent this week, according to futures data compiled by Bloomberg. That’s the highest since June 23, the day the U.K. voted to leave the European Union. Brexit sent investors scrambling for haven assets, driving Treasury 10-yields to a record-low 1.32 percent on July 6.

Since then, Treasuries have erased much of that advance amid signs of a stronger domestic economy, including above-forecast gains in June payrolls and retail sales. Citigroup Inc.’s U.S. Economic Surprise Index, which measures whether data beat or miss forecasts, surged to the highest since December 2014. A Bloomberg index of the Fed’s policy bias has entered positive territory, indicating a tightening bias. Officials will gather July 26-27 for the first time since the U.K. referendum as they weigh global risks against signs of U.S. expansion.

“The Fed is convinced it needs to raise rates, and is still looking for an opportunity to do so,” said Steven Ricchiuto, chief economist at Mizuho Securities USA Inc., one of 23 primary dealers that trade with the central bank. “Now the balance of risks looks fairly even, with the risks associated with inflation leaning higher.”

The benchmark 10-year note yield rose for a second week, climbing two basis points, or 0.02 percentage point, to 1.57 percent as of 5 p.m. in New York, according to Bloomberg Bond Trader data. The price of the 1.625 percent security due in May 2026 was 100 17/32. The yield is within 18 basis points of its closing level on June 23.

“We’ve seen 10-year Treasury yields move from historic lows up about 20 basis points on the back of strong payrolls data as well as on the retail sales data,” Subadra Rajappa, head of U.S. rates strategy at Societe Generale SA, a primary dealer, said on Bloomberg Television. “There is still some value in looking at market fundamentals.”

The latest reading on the Fed policy bias index, which accounts for financial conditions, economic data, and other metrics, stood at 0.2691.

Compared with Fed expectations before Brexit, “we have come full circle,” said Tom di Galoma, managing director of government trading and strategy at investment bank Seaport Global Holdings LLC in New York. “The possibility of the Fed doing something is certainly a lot higher than it was, though I still don’t think there are a lot of reasons to raise rates.”

Fed Outlook

Traders assign only about a 10 percent chance to a Fed hike this month as U.S. officials looking to raise rates while foreign central banks ponder the need for additional stimulus. The Bank of England left rates unchanged on July 14. European Central Bank President Mario Draghi said Thursday in Frankfurt that the effect of Brexit on the euro zone’s economic recovery was "very difficult to understand.”

That kind of rhetoric helps set Fed officials up for a hawkish statement next week, according to Ricchiuto, since they’ve established that Brexit fallout won’t require a dramatically accommodative policy response.

“All the central banks that people thought would ease are standing still, which means that the bank people thought would do nothing can think about tightening,” Ricchiuto said. “If they’re not terribly worried, why should we be?”

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