NEW YORK- Bond investors are bracing for more volatility from next week’s Federal Reserve meeting that is likely to deliver another steep interest rate increase, as market players continued to shed risky exposures and refrained from making big bets.
The Fed is widely expected to raise interest rates by 75 basis points (bps), as it did, shockingly, last month. What comes in subsequent meetings is up in the air. About a week ago the market was pricing in a full percentage point hike to be announced at the end of the two-day meeting on Wednesday.
So it’s an anxious environment. Many portfolio managers have maintained either a risk-neutral stance, or stayed short duration, opting as well for higher-quality names in the corporate bond space.
In a rising rate scenario, bond investors tend to reduce the duration of their portfolios. The longer the duration, the higher the losses if rates rise.
“Many companies are battening down the hatches…bracing themselves from the impact of the Fed’s tightening of monetary policy and the unknown of where inflation is going,” said Rob Daly, director of fixed income at Glenmede Investment Management.
“Bond investors, like us at Glenmede…have to continue to deal with this uncertainty around what the Fed might do. It is that uncertainty that I cannot get a handle on. The Fed has been wrong and the market has also been wrong.”
A disquieting string of economic news in recent weeks made the Fed look behind the inflation-taming curve.
The release of data showing the annual US inflation rate hitting a more that 40-year peak in June saw the market price in a 100-bps hike. Then two supposedly hawkish Fed officials — Christopher Waller and James Bullard — tamped that down saying the central bank would likely stick with 75 bps.
The spooked bond market hoisted volatility prices on derivatives called swaptions — options on interest rate swaps. Rate swaps are often used by investors to express views on where borrowing costs are headed.
Normalized volatility on shorter-dated swaptions such as one-month at-the-money options on one-year swap rates, that part of the curve sensitive to Fed policy, soared to 192.9 basis points in early July, the highest since at least February 2013, Refinitiv data showed. It was last at 155.6 bps.
Glenmede’s Daly said the firm has dialed down risk in the last few months, and is currently “neutral duration within our strategies.”
“I think the market is underestimating the amount (of hikes) the Fed can do.”
A 75-bp rise would bring the fed funds target range to 2.25 percent-2.5 percent. Fed funds futures on Friday have priced in an additional 180 basis points of cumulative tightening by the end of the year and showed a more than 60 percent chance of a 50-bps rate hike in September FEDWATCH. The Fed has raised rates by 150 bps so far this year.
Over the last few weeks though, eurodollar futures EDH3 have been pricing policy easing in the first quarter of next year.
