Fixed income investors are starting to position themselves for a pause in Federal Reserve rate hikes, perhaps as early as this week, as investors bet the current equity market turmoil, slowing growth signals and pressure from President Donald Trump could test the central bank's tightening resolve.
Benchmark 2-year Treasury note yields fell 2.5 basis points in overnight trading to 2.675% Tuesday, the lowest since May, as equity markets around the world followed Wall Street lower amid one of the worst December performances for U.S. equities on record. That move, coupled with slowing growth from major economies such as China and Japan and troubling data in credit and housing markets at home, is starting to raise the prospect of a pause in Fed rate hikes as early as this week.
"Coming into this week, the alarm bells are sounding in corporate credit and the US dollar is perched at its highest levels since early 2017," said Saxo Bank's head of FX strategy John Hardy. "It is clearly time for the Fed to blink and that is what the market is pricing - but how profound will the actual blink prove on Wednesday?"
The CME Group's FedWatch tool, tracks rate hike probability, is pricing in a 69.7% chance of a hike tomorrow that would take the range on Fed Fund to 2.25% to 2.5%, down down from 75.8% just one week ago. Odds for 2019 hikes are also peeling back, and now suggest just a 16.4% chance of a March hike and virtually no chance of a follow-up move in June.
That presents a significant challenge to the Fed's so-called "dot plots" which suggest at least two, and possibly four, rate hikes next year as the central bank eyes developments in the tightest labor market in nearly 50 years and GDP growth of around 3% in the world's biggest economy.
However, cracks in the Fed's hawkish rate hike case are starting to appear. Not only is global growth starting to show signs of significant weakness -- Japan slashed its current and next year GDP forecasts today while economic activity in the Eurozone slowed to its weakest pace in four years last month -- but data in housing and credit markets is also starting to wobble.
Homebuilder sentiment fell to the lowest levels in more than three-and-half years last month, the NAHB said Monday, while the Bank for International Settlements warned earlier this week that the "bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors."
"Should this debt be downgraded if and when the economy weakened, it is bound to put substantial pressure on a market that is already quite illiquid and, in the process, to generate broader waves," the BIS's head of monetary and economic development, Claudio Borio, warned Sunday.
Others argue the Fed should consider holding fire this week amid the gathering market turmoil, which has seen U.S. stocks fall nearly 8% so far this month, the worst December since the 1930s, and global bond yields fall to mutl-month lows.
"The bond market is basically saying, 'You know, Fed, there's no way you should be raising interest rates'," DoubleLine Capital's Jeffrey Gundlach told CNBC Monday, while Stan Druckenmiller and Kevin Warsh wrote in the Wall Street Journal that "the U.S. economy can sustain strong performance next year, but it can ill afford a major policy error, either from the Fed or the rest of the administration."
President Trump has also added to investor pressure on the Fed, Tweeting Monday (for the third time since October) that he thought it was "incredible" for the central bank to be considering rate hikes in a low inflation environment.
Still, the baseline assumption for Wednesday's rate decision, which is scheduled for 2pm eastern time, is for the bank to raise rates for the fourth time this year -- and the eighth since 2015 -- before pausing into 2019 in order to more closely examine incoming data.
"The Fed dropped the line that monetary policy was "accommodative" back in September and recent comments from Fed Chair Jay Powell suggest policymakers now acknowledge they are getting close to neutral policy," said ING's James Knightley and Jonas Goltermann. "However, we believe that policy is still some way off from being restrictive and while there are certainly more headwinds, there are clear positive that can keep growth running at a respectable rate."