Pimco Joins Bond Traders Seeing Fast-Tracked Fed After Trumpby and
Overnight swap market signals extra rate increase under Trump
Treasury yields soared after election as inflation seen rising
So much for bond traders’ speculation that Donald Trump becoming president would delay the Federal Reserve from deciding to raise interest rates. Now they’re wondering how many times policy makers could increase them in 2017.
Investors from Pacific Investment Management Co. to TIAA Global Asset Management see the surge in long-term U.S. Treasury yields that came after Trump’s election as a sign inflation will be on the rise. That means the long-dormant part of the Fed’s dual mandate could force policy makers to act more swiftly to raise borrowing costs than they have in 2016, when they held off time and time again after increasing their target rate to a range of 0.25 percent to 0.5 percent at the end of last year. Scott Mather at Pimco says the central bank may boost its benchmark three times by the end of 2017.
Swaps trading shows the expectation for a faster tightening cycle. Overnight index swap contracts implied the central bank’s benchmark rate will be 1.09 percent in two years’ time, compared with the expected 0.83 percent on Nov. 7, the day before the U.S. election. That means the market is pricing in another hike as Trump’s win and Republicans controlling Congress portends a wave of spending to bolster the U.S. economy.
“We see a higher and more balanced inflation forecast and more rapid normalization of policy,” Mather, chief investment officer for core strategies at the Newport Beach, California-based company, wrote in a note. “This means the Fed will move faster on rate increases than the market had been pricing for in the year ahead,” he said, adding that he expects “two to three rate hikes before the end of 2017.”
Trump, the 70-year-old real estate magnate and president-elect, has made pledges including cutting taxes and spending as much as $500 billion on infrastructure. His proposals would boost the nation’s debt by $5.3 trillion, the non-partisan Committee for a Responsible Federal Budget estimated. The government’s marketable debt has already more than doubled under Barack Obama, to a record of almost $14 trillion.
The market-implied chance of a December rate hike by the Fed is 84 percent, compared with 76 percent at the end of last week, according to fed fund futures data compiled by Bloomberg. The odds briefly plunged below 50 percent as election results came in Tuesday night, based on U.S. overnight indexed swaps that trade 24 hours a day. Those usually have a slightly lower probability than the calculations based on futures.
Treasury 10-year yields rose five basis points, or 0.05 percentage point, to 2.1 percent as of 9:10 a.m. in New York, after surging 20 basis points Wednesday, according to Bloomberg Bond Trader data. U.S. 30-year yields climbed to 2.9 percent, after jumping 23 basis points to 2.85 percent the previous day.
A measure of demand fell to the lowest since 2009 at a $23 billion auction of Treasury 10-year notes on Wednesday, with interest from foreign buyers particularly weak. A gauge of the yield curve steepened as longer-dated debt underperformed and the uncertainties surrounding a Trump presidency clouded the immediate monetary policy outlook for some. The U.S. is selling $15 billion of 30-year bonds on Thursday.
Still, the moves may reflect how a December increase is no longer a foregone conclusion, according to Jim Vogel, head of interest-rate strategy at FTN Financial in Memphis, Tennessee.
“They could easily postpone until the first meeting in 2017 without any risk to the economy getting out of control,” Vogel said.
Much of the loss in Treasuries stemmed from bets about future price growth. The U.S. 10-year break-even rate, a measure of the market’s inflation expectations over 10 years, has surged 16 basis points over the past two days to 1.9 percent, the highest intraday level since July 2015. The 30-year break-even rate jumped to 2.08 percent, the highest in two years.
If Trump rolls out high levels of fiscal stimulus, “the Fed may then be forced to react to that at a faster pace as it gets to or slightly exceeds its 2 percent inflation target,” said New York-based Joe Higgins, manager of fixed-income strategy and the TIAA-CREF Bond Fund at TIAA Global Asset Management, which manages $915 billion in assets. “It’s not inconceivable that the pace of Fed increases is at a faster pace than it otherwise would.”
Bond investors are only just catching up to the Fed’s own projections. Two years from now, at year-end 2018, the median projection of Federal Open Market Committee members is for the benchmark rate to climb to 1.875 percent, still higher than the level implied by swaps.
Policy makers have persistently lowered their expectations for raising interest rates after events from China to Brexit have left them sidelined throughout the year. At the Fed’s December 2015 meeting, the median projection was for the benchmark to rise to 3.25 percent by the end of 2018.
Trump’s victory requires a re-calibration of expectations for inflation and Fed policy, for a bond market that had for a period questioned whether rates would stay near zero for years to come, and where some were seeing 10-year yields sliding to 1 percent or lower.
“We had thought one to two rate hikes next year, and I had been more in the one camp. That now probably moved to more like two to three,” said John Bredemus, Minneapolis-based vice president at Allianz Investment Management, with more than $700 billion in assets under management. “You can’t generate too much inflation, too much additional spending and too high of rates without impacting the dollar and affecting the economy from a different perspective. The Fed understands this.”