Global financial markets got uglier while Federal Reserve officials were on their August hiatus, but bond traders are wagering that won’t be enough to deter them from pressing on with monetary-policy tightening in the world’s largest economy.
Turkey-induced turmoil has spread across emerging markets, roiling countries from Argentina to South Africa and fueling fears of further contagion. From developing-nation stocks to copper and European banks, bear markets now abound. American short-term rates, however, remain stubbornly close to their post-crisis highs. The yield curve has also pushed back to its lows of the cycle and speculators in Treasury futures are holding record short positions.
This week’s gathering of central bankers at the Kansas City Fed’s annual Jackson Hole symposium could well provide clues as to whether such confidence is warranted, and minutes from the Fed’s Aug. 1 policy meeting also loom large. In recent years, international uncertainty has been more than enough to prompt officials to tap the brakes on tightening. Yet with inflation continuing to run above the central bank’s 2% target and America’s decoupling from the global downtrend continuing, this time may be different.
“Before, an overseas hiccup would cause the Fed to skip a hike,” said Michael Cloherty, head of U.S. interest rate strategy at RBC Capital Markets. “Now it would have to be real ugly turbulence across the full spectrum to cause them to delay.”
As it stands, traders are almost fully pricing in a rate hike at the Fed’s next policy meeting just over a month from now, and about 50-50 odds of a second increase by year-end, based on fed funds futures pricing. The spread between December 2018 and 2019 eurodollar contracts suggests they expect an additional one-and-a-half rate hikes next year.
Hedge funds and other large speculators are equally confident in the central bank’s tightening trajectory. They boosted wagers against 10-year Treasury futures to a record 698,194 contracts, according to U.S. Commodity Futures Trading Commission data for the week through Aug. 14. That’s even as ructions in emerging markets fueled the biggest weekly selloff in developing-nation shares since February.
And the spread between 2- and 10-year Treasury yields on Friday narrowed to the least since August 2007 as investors continue to crush any signs of steepening.
Fed Chairman Jerome Powell will headline this year’s Jackson Hole gathering of prominent central bankers and economists with a speech about monetary policy in a changing economy on Aug. 24.
Yet given the conference has historically offered only modest insight into the trajectory for monetary policy, Cloherty says he expects this week’s release of minutes from the Federal Open Market Committee’s Aug. 1 meeting to be more consequential for the bond market, especially if the topic of balance-sheet normalization was discussed.
Powell noted at his semi-annual testimony to Congress last month that the Fed would take up the question about the size of its balance sheet “fairly soon.” Mark Cabana, head of U.S. short-term interest rates at Bank of America, said more direction from the central bank “needs to be forthcoming.”
It would be a nice time for the Fed to revisit the topic “and provide some guidance to the market on how they’re thinking about the process,” he said.
Balance-sheet deliberations are becoming increasingly important as Wall Street pulls forward forecasts for when the central bank will conclude its unwind. Credit Suisse Group AG analyst Zoltan Pozsar said last week that the Fed may be forced to halt the tapering process before year-end due to America’s widening fiscal deficit, as surging Treasury-bill issuance puts upward pressure on the effective fed funds rate just a policy makers work to keep it steady.
“These concerns are likely accelerating the focus on this internally,” Cabana said. “They need to guide the market a little more about how they’re thinking.”
