Markets Come to Grips With the Fed on Interest Rates

Markets – With the latest jobs report, cracks started appearing in investor optimism, and Tuesday’s stubbornly high inflation data shook traders again. Now longer-dated wagers are finally beginning to mirror the central bank’s latest forecast.

Expected federal-funds rate

According to FactSet, derivatives markets now show the federal funds rate peaking near 5.25% in August. Hopes that the Fed would cut rates several times this year faded: The benchmark rate is forecast to end the year above 5.1%.

Wednesday’s retail-sales print—showing the hottest consumer-spending increase in nearly two years—solidified traders’ positioning.

​​Wall Street’s base case at the start of February, via fed-funds futures contracts, was for the Fed to raise rates somewhere between 4.75% and 5% around midyear before cutting them by 0.50 percentage points in the latter half of 2023.

“The market got very much ahead of itself,” said Joseph Lewis, managing director and head of corporate hedging and FX solutions at Jefferies.

Companies have struggled to manage the market’s shifting expectations for where the Fed will take rates, even as corporate hedging activity is now higher than at any time in the past decade, according to Wall Street Journal Print Edition App

Higher rates pummeled stocks last year, particularly shares of tech and growth companies, by reducing the amount investors were willing to pay for earnings expected far in the future. As Wall Street grew convinced that inflation was falling and that the Fed would pivot to cutting rates, investors piled back into speculative assets that had soared when the Fed had an ultra-accommodative stance.

Stocks popped to start 2023, led by tech shares. Bond prices rebounded from their worst year on record as yields fell. Crypto made a resurgence, and traders rushed into bullish options to profit from the markets’ chaotic recovery.

The euphoria began to ebb earlier this month when January’s employment report showed the economy added jobs at a much faster clip than expected, and the unemployment rate fell to its lowest level since 1969.

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“The change in sentiment on rates has been remarkable,” said Doug Fincher, a portfolio manager at Ionic Capital Management. “As aggressive as people were about lower future rates in mid-January, the reversal has been equally as pronounced.”

Mr. Fincher said the dovish expectations were confounding. He said his hedge fund looked to capitalize by wagering against two predominant trades: Ionic Capital bet that rates would peak higher than the market expected and that cuts would be less swift.

Bond Yields

The back-and-forth over the rate picture is likely far from over. Even after U.S. stocks’ worst performance in more than a decade in 2022, many analysts and portfolio managers warn that markets remain vulnerable, partly because valuations are still elevated in many areas. Some investors say one source of risk is that the 2023 rally has been led in considerable measure by speculative assets that are subject to large swings given any perceived change in the economic, political, or market outlook.

According to futures contracts, the most likely scenario at the next pair of Fed meetings is for two additional quarter-point increases. As for the June meeting, traders are divided between a pause in rate increases and another quarter-point raise.

Short-term bond yields climbed this week. The two-year Treasury yield rose to 4.625% on Wednesday, its highest since November. The work on the six-month bill broke above 5%, its loftiest since 2007.

The Fed weighs interest rates against unemployment and inflation—trying to tighten conditions to maintain stable prices, but not enough to cause swelling job losses. Despite roughly a year of rate increases, the labor market has proved surprisingly resilient, which investors believe gives the Fed more room to raise rates.

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Traders said that why the Fed will eventually shift to ​cutting ​rates ​has been a source of uncertainty.

The Fed might be able to reverse course because inflation is falling toward its target​. Conversely, a rapid market or economic deterioration could lead officials to cut rates.

Growth worries remain inconspicuous in the corporate bond market, where credit investors are particularly attentive to companies’ ability to make future debt payments. The extra yield over U.S. Treasurys that investors demand to hold corporate bonds—both high-yield and investment-grade—recently dropped to their lowest levels since April.

Accordingly, the Federal Reserve Bank of New York’s corporate bond market distress index fell to a seven-month low in January. While the Fed’s tightening campaign has yet to fracture the economy noticeably, the health of companies’ balance sheets will remain a significant bellwether.