The Daily Prophet: Bond Traders Get Defensive Ahead of the Fed

Connecting the dots in global markets.

All the talk of a nasty bear market in bonds has diminished over the past month as a retreat in stocks and worries about a global trade war fostered demand for safe assets. But judging by the latest survey of fixed-income investors by JPMorgan, it's not time to sound the all clear.

The firm, which is the world's biggest underwriter of bonds, said its weekly sentiment index fell by the most this year, dropping 8 points to minus 25. Few traders are willing to bet that the worst is behind the bond market as Federal Reserve officials give no sign they are ready to back away from their projections for three interest-rate increases in 2018, starting with a boost in the federal funds rate on Wednesday. By some measures, the market is pricing in a not insignificant 30 percent chance that the central bank will hike rates four times. With inflation starting to stir, the Fed will take no chances in responding to a brightening economic picture driven by faster global growth, a pick-up in investment, and the impact of massive U.S. tax cuts and increased government spending, according to Bloomberg News' Christopher Condon and Catarina Saraiva.

"Where are the bullish scenarios for tomorrow? Difficult to find because the Fed has little incentive to throw around dovish thoughts this early in the year," Jim Vogel, an interest-rate strategist at FTN Financial, wrote in a research note. "When it comes to a less aggressive policy stance, the Fed is very slow to act. Its refusal to acknowledge slowing inflation in its forecasts last year is the perfect example of the central bank's adamant support of gradual hikes regardless of current evidence."

For most of 2017, the main driver of equities was the notion that the global economy was enjoying its first synchronized upswing since 2010. That helped boost earnings and justified nosebleed level valuations. But this year, stocks have started to show some cracks, with MSCI All-Country World Index some 6 percent below its intraday peak of 550.63 on Jan. 29. One could point to a slew of reasons for the recent weakness, from the troubles in the tech sector to more hawkish central banks to possible trade wars. But Bank of America Merrill Lynch's latest monthly survey of fund managers provides what is perhaps the biggest explanation why equities aren't rebounding as fast as they did during setbacks last year. The firm said 74 percent of investors surveyed believe the global economy is in late cycle mode, the highest percentage in the survey's history. Expectations for faster global growth fell 19 percentage points to 18 percent in March, the lowest level since the U.K. voted to leave the European Union in June 2016. The net percentage of investors who would like to see companies improve their balance sheets is at the highest level in over 8 years.

The good news for dollar bulls is that the U.S. currency has stopped falling. The bad news is that it's not going up. In fact, it's not doing much of anything. The U.S. Dollar Index, a widely tracked gauge, has been confined to a range of just 3 percent over the past two months, displaying signs of exhaustion after plunging as much as 15 percent since the start of 2017, according to Bloomberg News' Alexandria Arnold and Robert Fullem. Strategists expect the malaise to linger at least through the end of next quarter. The median of more than 20 estimates is for the Dollar Index to end June at 89.1, compared with 90.337 on Tuesday. That's not to say there aren't plenty of triggers that send the dollar flying higher or plunging anew. Arnold and Fullem report that bulls say signs of faster inflation, the potential for a global trade war and extreme bearish positioning in the market could give the greenback a boost. The bears say global monetary policy convergence could further diminish the appeal of the dollar as foreign central banks start to tighten their policies.

Investors have accumulated the biggest holdings in gold-backed funds in almost five years as President Donald Trump rocks the boat on trade and equity markets wobble. Purchases are swelling even with the Fed poised to raise rates again, according to Bloomberg News' Ranjeetha Pakiam. Typically, higher rates can hurt non-interest-bearing assets such as gold. Worldwide holdings in exchange-traded investments jumped to 2,267 metric tons, the most since May 2013, according to a tally compiled by Bloomberg as of Monday. That’s up almost 2 percent this year, while futures have flatlined. The expansion in 2018 follows a four-quarter, 230-ton increase last year. “The geopolitical risks that have emerged in recent months have certainly instigated some haven buying,” Daniel Hynes, a senior commodities analyst at Australia & New Zealand Banking Group, told Bloomberg News. He cited the threat of a trade war after Trump imposed metals tariffs, risks from Robert Mueller’s probe, White House firings, as well as Monday’s stock market sell-off. Concerns over the possibility of more rate increases than expected have mitigated some of the haven buying, and weighed on gold prices, according to Hynes. Futures traded at $1,311.60 an ounce on the Comex on Tuesday, little changed this year.

Yields on dollar-denominated emerging-market debt have climbed more in 2018 than at this point in any year since 2005. The average yield jumped 44 basis points this year through Friday to 4.95 percent, near the highest level since 2016, Bloomberg Barclays indexes show. Investors are concerned that trade protectionism will hurt growth and faster rate increases in the U.S. will dim the appeal of developing-nation bonds, according to Bloomberg News' Selcuk Gokoluk. Finance ministers and central bankers from the Group of 20 economies highlighted the importance of international trade in a statement Tuesday, while warning that a faster pace of global monetary tightening as well as geopolitical tensions threaten to undermine the broadest growth since 2010, Bloomberg News reported. “Strong fundamentals, sound policies, and a resilient international monetary system are essential to the stability of exchange rates, contributing to strong and sustainable growth and investment,” the world’s top developed and emerging nations said in a joint communique at the close of a two-day gathering in Buenos Aires.

Even though it's pretty much a foregone conclusion the Fed will raise rates Wednesday, that doesn't mean bonds will get pummeled. The benchmark Bloomberg Barclays U.S. Aggregate Index of fixed-income securities rose on each of the three days last year that the central bank boosted its target for the federal funds rate. The reason is that the Fed has been relatively sanguine about inflation. After tightening policy Dec. 13, the central bank kept its outlook for consumer prices largely unchanged. But there's good reason to believe Wednesday could be different. Not only has the market's expectations for inflation increased since the last Fed meeting, but a novel inflation measure by the influential New York Fed has risen to its highest since 2006. At a recent 3 percent, the so-called underlying inflation gauge is a broad-based index that includes consumer and producer prices, commodity prices and real and financial asset prices. The New York Fed staff says the index detects cyclical turning points in underlying inflation and has a better track record than the consumer price series.

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