Bond market counting on the Fed to do less when it comes to interest rate hikes

Published Tue, May 24 20224:40 PM EDTUpdated Wed, May 25 20229:10 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Stock investors have been scared by rising bond yields, and now bond investors are spooked by the bearishness of the stock market's sell-off. The markets are worried about a softening economy and are now pricing in expectations that the Federal Reserve may not be able to raise interest rates as much as previously expected. "I think first, you're seeing in the market bond yields going down as equities go down, which means the market is pricing in more of a slowdown," said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management. "Markets are pricing in a downgrade to growth expectations and a downgrade to earnings." Falling stock prices are just one worry, but bond strategists say the stock market's continuing decline is a direct reflection of slowing growth in the economy. The S & P 500 has fallen as much as 20% off its high and was down 0.8% Tuesday. Caron said the tone of the bond market has changed in the last several weeks, and investors are now expecting fewer interest rate hikes from the Fed. They are also adding longer-dated securities to their portfolios. "We're seeing people add duration. We're seeing money come in and buying long duration bonds because they're acting as a hedge to risky assets," said Caron. "I think that's the first time I've seen that. For the first time this year we're seeing people add duration to portfolio as a hedge." The benchmark 10-year Treasury yield has been on a downward trajectory recently. It was above 3% on May 18 but it has since fallen sharply. The 10-year is key because it influences rates on mortgages and other loans. On Tuesday, the 10-year fell through 2.79%, an area of support, and dipped as low as 2.71%. It was at 2.75% in afternoon trading. "I think it's telling us the market is becoming increasingly concerned about the state of the recovery, and how much tightening the Fed will be able to pull off," said Ben Jeffery, rate strategist at BMO. The 10-year has been tethered to the stock market for a good part of this year. As the yield rose rapidly, tech and growth names wilted. Yields have risen in lockstep with expectations for Federal Reserve interest rate hikes. Cheap money helps fuel valuations, and stocks that have growth prospects far into the future are the most vulnerable when interest rates start to rise. So stock strategists see a declining yield somewhat like the release of a pressure valve. But that development may not be too uplifting for the stock market, since slower economic growth would also hurt stocks. "It seems now for the last week or 10 days, growth has dominated the discussion, where for just some time it was inflation, inflation, inflation," said Michael Schumacher, director of rates strategy at Wells Fargo. "You could say, equities equal growth." Bond yields, which move in the opposite direction of bond prices, have been falling on concern that weaker economic data warn of a slower economy ahead. At the same time, Fed Funds futures are pricing in reduced expectations for Federal Reserve interest rate hikes, on fears the Fed's own increases will cause more problems for the economy as it slows down. The latest batch of weak data drove yields lower Tuesday. New home sales, for instance, fell more than 16% in April. Markets await durable goods data Wednesday morning and the minutes from the Fed's last meeting released in the afternoon. That was the meeting where the central bank raised interest rates by 50 basis points. A basis point equals 0.01 of a percent. Schumacher said Fed Funds futures had been pricing in 1.94 percentage points of additional Fed rate hikes this year, but that fell to 1.83 points after the morning data Tuesday. The futures market was still positioned for 50 basis point hikes in both June and July, but expectations were dropping for 50 more in September. "Today it feels like a pretty big break," said Schumacher. "It's a holiday week. Liquidity is light ... Volatility has been super high. People are skittish taking off a lot of risk ahead of the long weekend." The economy contracted at a pace of 1.4% in the first quarter, and the Atlanta Fed GDPNow tracke r forecast now sees positive growth of 2.4% in the second quarter. Even with the decline in yields, strategists do not see much more downside. "It's going to be hard to see the 10-year Treasury yields to get much below 2.60%, unless you believe the Fed is not going to the neutral policy rate," he said. He added that level would be at 2.5%. "If that does happen, the market is pricing that the Fed does not get to 2.5% or there's a recession and the curve inverts," said Caron. "As long as the Fed is hiking it's going to be hard for those yields to fall."