Investors have rapidly increased bets that the Federal Reserve will cut US interest rates this year in a frenzied day of trading that strained the functioning of markets.
The turbulence was such that the main US futures exchange temporarily halted trading in certain interest rate contracts. Traders backing away from risk widened the gap between prices offered and bid for US Treasury securities. Deals in the $22tn Treasury market — the deepest and most liquid in the world — took longer and were more expensive to execute.
The market moves on Wednesday came a week before the Fed is scheduled to decide on interest rate levels at its next monetary policy meeting after months of increases in the past year. Many bond traders now expect the Fed will not raise rates though some still see a chance of a 0.25 percentage-point increase as it battles stubborn inflation, according to pricing in futures markets. Expectations of a half-point increase prevailed in markets as recently as last week.
Pricing in futures markets suggested that the Fed could begin to cut rates as soon as June by a quarter point and deliver further reductions to bring the central bank’s benchmark rate down to 3.9 per cent, which would be more than 1 percentage point lower than an expected peak of 4.9 per cent in May.
Rate expectations have changed in the past week after failures of Silicon Valley Bank and two others in the past week triggered fears of a broader banking crisis.
Quickly shifting rate projections triggered price fluctuations that forced exchange operator CME Group to halt trading for two minutes in certain contracts linked to the Sofr borrowing benchmark and federal-funds futures markets. Trading has since resumed.
“There is a circuit breaker that gets tripped if those futures move more than 50 basis points, and that happened this morning,” said Tom Simons, money market economist at Jefferies.
Traders said such a halt was rare, as these interest rate futures markets tend to move in small increments based on signals from the Fed and official data.
The yield on the two-year Treasury note, which is more sensitive to interest rate expectations, fell 0.27 percentage points on Wednesday to 3.98 per cent. It has plunged from more than 5 per cent last week in moves not seen since the late 1980s.
The 10-year Treasury note yield fell 0.21 percentage points to 3.4 per cent. Bond yields move inversely to prices.
“Some market participants were looking for the Fed to keep hiking until something broke. The question now is, was this it?” said Michael de Pass, global head of linear rates trading at Citadel Securities, referring to the bank sell-off.
Swings in the Treasury market were big enough to widen the spread between bids and offers for Treasuries, making it more difficult to buy and sell the securities.
“Liquidity is off and has the possibility to deteriorate further,” said Michael Lorizio, a fixed-income trader at Manulife. “It makes sense that given the volatility, bid-ask spreads have widened.”
The cost to make trades has increased, though investors were still saying it was possible to get deals done. One portfolio manager said: “We’re doing trades of any size on the phone and negotiating prices more carefully. Going to the screens to execute electronically is painful.”
While some of the shift in futures markets is linked to expectations for Fed policy, traders said it was also likely to reflect the unwinding of leveraged positions that had been building up since the start of the year.
“Speculators had been the shortest on bonds they had been in some time,” said Simons. “Now we’ve had a risk event and it has been a scramble to cover those positions.”
That build-up was reflected in data from the Commodity Futures Trading Commission, which showed the largest ever short position — a bet on higher rates — in two-year Treasuries in mid-February. The CFTC data is typically released weekly but has been delayed due to a recent cyber attack on Ion Markets, a financial technology group that serves derivatives markets.
Rate expectations first began to shift after concerns mounted over the fate of Silicon Valley Bank late last week. They dropped further on Wednesday after Credit Suisse said its largest shareholder would not provide the Swiss bank with more capital.
Meanwhile, the US reported that producer prices fell 0.1 per cent in February, versus expectations for a small increase. Wednesday’s report tempered news from Tuesday that US consumer prices continued to rise, inflation data that puts pressure on the Fed raise rates further.
“If we take a step back, the Fed has done a fair amount in terms of the hiking cycle. And you look at when the hiking cycle started, we’re now at the point where you’d really expect the effects of the hikes to kick in earnest,” said de Pass at Citadel Securities.