Markets are starting to acknowledge overstep on easing outlook

[NEW YORK] A reality-check on the threat of a recession is shaking the bond market's conviction on the extent of the Federal Reserve's easing cycle.

For the first nine months of this year, wagers on the path of interest rates showed a widening gap between traders and the Fed. The market's pundits saw policy makers getting dragged into a series of aggressive rate cuts, as the US and China drew battle-lines over tariffs and the global growth outlook worsened.

Increased optimism on both fronts this month has buckled that trend. For the first time this year, markets are converging to the Fed's view that interest rates aren't headed much lower, as Fed chairman Jerome Powell suggested this week when the Fed delivered its second quarter-point rate cut in a row. January Fed fund futures contracts are now pricing in just one more in 2019, and vice chairman Richard Clarida on Friday seemed amenable to that.

"The market is coming to the Fed and readjusting its expectations," said Putri Pascualy, a portfolio manager at Pacific Alternative Asset Management.

She points out that this is "a meaningful change from what's been going on this year, where the question was whether the Fed was behind the curve and it was going to accelerate rate cuts to meet market expectations".

At the height of the Treasury market's headlong rally in August, when fears of a global recession reached a fever pitch, Fed fund futures were pricing in a September cut and as much as a half-point more by year end. As of now, they're positioned for barely a quarter point.

In eurodollar option markets, a growing number of traders are cashing out of dovish bets, with the latest purge coming in the US morning Friday. The positions taken out stood to benefit from an additional 50 basis points of Fed cuts this year.

Traders are also now charting a shallower path of rate cuts for next year, with the target rate now seen falling to 1.3 per cent by the end of 2020, according to the January 2021 contract, versus 0.9 per cent anticipated as of Sept 4.

That said, over the past week rate cut positioning for next year has begun to rebuild, on the basis that the Fed's reluctance to cut now will simply force it to move later. That's the scenario in which this "data dependent" Fed is finally confronted with enough evidence to confirm that US growth is in fact worsening.

Judging by the Fed's updated views on the path of rates, policy makers have clearly become more receptive to easing. Their "dot plot" of projections shows seven members now envisage another rate cut this year - back in June, none saw it getting that low. A slim majority still sees no cut at all through this year or next, and none project more than one. Policy makers will have more than enough opportunity to elaborate on this diversity of opinions in the coming week, when many - including two of the three dissenters to this latest vote - are slated for speaking engagements across the country.

The belief among some investors that easing may simply be delayed is borne out in the shape of the Treasury yield curve, says BNP Paribas head of G-10 rates strategy, Shahid Ladha. A sell-off at the front of the curve, on dimmed expectations for easing, has pushed it flatter. And buying in long-dated Treasuries has contributed to the move. That buying, Mr Ladha said, reflects a pretty strong suspicion that while further cuts may not be imminent, they'll have to be made.

"Even if it takes a little longer for the Fed to deliver the next cut, the long end remains convinced it is coming," Mr Ladha said.

BLOOMBERG