Turbulence tightens interest rate markets as traders bet on Federal Reserve tapering
Investors surged their bets that the Federal Reserve will cut U.S. interest rates this year in a frenetic trading day that strained markets.
The turbulence was so severe that the main US futures exchange temporarily halted trading in certain interest rate contracts. Risk-averse traders widened the bid-ask spread for US Treasuries. In the $22 billion Treasury market—the deepest and most liquid market in the world—deals took longer and were more expensive.
Wednesday’s market moves came a week before the Fed is scheduled to decide on interest rates at its next monetary policy meeting after months of hikes over the past year. Many bond traders now expect the Fed to keep rates unchanged, though some still see a 0.25 percentage point hike as futures markets price it as it struggles with stubborn inflation. Expectations for a half-point increase were still valid in the markets last week.
Pricing in futures markets suggested the Fed could start cutting interest rates by a quarter point as early as June and make further cuts to bring the central bank’s benchmark rate down to 3.9 percent, more than 1 percentage point lower than expected. Peak value of 4.9 percent in May.
Interest rate expectations have changed over the past week after the failure of Silicon Valley Bank and two others in the past week sparked fears of a broader banking crisis.
Rapidly changing interest rate forecasts triggered price swings that forced exchange operator CME Group to halt trading for two minutes in certain contracts linked to the Sofr borrowing benchmark and the federal funds futures market. Trading has since resumed.
“There is a circuit breaker that trips when futures move more than 50 basis points, and that happened this morning,” said Tom Simons, chief financial economist at Jefferies.
Traders said such a halt was rare because these futures markets typically move in small increments based on Fed signals and official data.
The yield on the two-year treasury bill, which is more sensitive to interest rate expectations, fell by 0.27 percentage points to 3.98 percent on Wednesday. It fell from more than 5 percent last week in moves not seen since the late 1980s.
The yield on the 10-year treasury bill fell by 0.21 percentage points to 3.4 percent. Bond yields move inversely with prices.
“Some market participants were looking for the Fed to hike until something went wrong. The question now is, was it? said Michael de Pass, global head of linear interest rate trading at Citadel Securities, referring to the bank sale.
The swings in the Treasury market were large enough to widen the bid-ask spread for Treasuries, making it difficult to buy and sell the security.
“Liquidity is off and there is the potential for it to deteriorate further,” said Michael Lorizio, fixed income trader at Manulife. “It makes sense that bid-ask spreads have increased due to volatility.”
The cost of trades increased, although investors still said deals were possible. One portfolio manager said: “We do deals of any size over the phone and negotiate prices more carefully. It’s painful to go to the screen to do it electronically.”
While some of the movement in futures markets is related to Fed policy expectations, traders say it also likely reflects the unwinding of leveraged positions that have been building since the start of the year.
“Speculators were the most shorted bonds in a while,” Simons said. “We just had a risky event and it was very difficult to cover those positions.”
That build-up was reflected in data from the Commodity Futures Trading Commission, which in mid-February showed the largest ever short position — a bet on higher interest rates — in two-year Treasuries. CFTC data is usually released weekly, but has been delayed due to a recent cyberattack on Ion Markets, a financial technology group that services derivatives markets.
Interest rate expectations first began to shift late last week after concerns about the fate of Silicon Valley Bank. They fell further on Wednesday after Credit Suisse said its largest shareholder would not provide more capital to the Swiss bank.
Meanwhile, the United States reported that producer prices fell 0.1 percent in February, compared with a small increase expected. Wednesday’s report moderated Tuesday’s news that U.S. consumer prices continued to rise and that inflation data made it more difficult for the Fed to raise interest rates.
“If we take a step back, the Fed has done quite a bit in terms of the hiking cycle. And if you look at when the hike cycle started, we’re now at a point where we would really expect the effects of the hikes to kick in in earnest,” said de Pass at Citadel Securities.