(Bloomberg) — Bond traders are lacking true conviction about the Federal Reserve’s policy intentions for the first time since the central bank’s frenetic tightening cycle began a year ago.
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Ahead of Wednesday’s Fed decision, swaps are priced for just an 80% chance of a quarter-point rate hike. That marks a departure from every other Fed meeting over the past year, in which traders have fully priced at least one such move. Instead, the debate until now has been over whether rate hikes would be in 25-, 50- or 75-basis-point increments.
The relative lack of conviction underscores how complex the problem confronting policymakers has become in the wake of the first major US bank failures in more than a decade. Many investors and economists now see a case for a pause, which would allow the Fed time to assess the damage and the extent to which a nascent credit crunch among regional lenders stands to weigh on the economy.
“The Fed could get away with hiking and being dovish about the outlook, but they could also get away with no hike and say they will come back later,” said George Goncalves, head of US macro strategy at MUFG Securities Americas in New York.
“Market functioning has been used as an excuse more than once by the Fed to justify a pause,” Goncalves said, noting poor liquidity in the Treasury market that has contributed to extreme volatility and huge daily swings in benchmark yields. “You can’t fault them for skipping a hike due to the market volatility.”
The uncertainty in markets is reflected among professional forecasters, too: 11 of 98 economists surveyed by Bloomberg expect the Fed to announce a pause Wednesday, while one shop — Nomura Securities — even expects a quarter-point rate cut.
Muddying the waters at this stage is the fact that recent jobs and inflation data suggest the economy has responded very little to the more than four percentage points of rates hikes the central bank has implemented so far. Before the bank failures, that had many officials inclined to keep tightening and push the benchmark interest rate toward at least 5.5%.
Prior to the recent market turmoil, swaps were priced for the Fed’s tightening cycle to continue through September. Now, they indicate a peak for rates in May.
While Fed Chair Jerome Powell on Wednesday will probably express confidence in recent measures designed to ring-fence stresses in the banking system, economists and bond investors see regional lenders pulling back from extending new loans and tightening standards. That would suggest the Fed is going to get a weaker economy and abating inflation pressures without having to push rates much higher.
“In the medium term — six to 12 months — the terminal rate won’t be as high as the market previously thought, above 5.5%, because the Fed is near the point of breaking something and the economy is going to slow down as credit conditions tighten,” said John Madziyire, portfolio manager at Vanguard.