Bond Report: Treasury yields a touch softer in muted trade ahead of Fed decision

Markets are pricing in an 88% probability that the Fed will raise interest rates by another 25 basis points to a range of 4.75% to 5.0%, according to the CME FedWatch tool.

The central bank is expected to take its Fed funds rate target to 4.9% by May, according to 30-day fed funds futures.

A year ago the Fed’s main interest rate was effectively zero, but it has tightened monetary policy aggressively in response to surging inflation, which though off the four-decade highs recorded several months, remains three times the central bank’s 2% target.

The Fed’s decision follows a period of extreme volatility in bond markets as investors have tried to work out how much the central bank’s determination to curb inflation will be compromised by a desire not to exacerbate fractures in the banking system.

The ICE BoAML MOVE index, a gauge of expected Treasury volatility, late last week traded at its highest level in 15 years.

The difficulties central banks are facing were illustrated by new inflation data from the U.K. on Wednesday. Ten-year gilt
TMBMKGB-10Y,
3.477%
yields rose 7.7 basis points to 3.446% after a report showed consumer price rises accelerated to 10.4% in February, a move seen cementing another 25 basis point rate hike by the Bank of England on Thursday.

What are analysts saying

“The FOMC faces two questions at its current meeting. First, what is the best response for now to the last two weeks of havoc in the banking system. A plausible case can be made that in light of the heightened uncertainty regarding financial stability and, in turn, the economic outlook, the Fed would be well-served to hold off and let the dust settle. Such a step would certainly not be unreasonable,” said Stephen Stanley, chief U.S. economist at Santander.

“However, in my view, the proper course of action is to move forward with a rate hike. The current economic landscape clearly justifies additional rate hikes, and proceeding would send a powerful signal that officials believe that the recent upheaval will be brought under control in a way that limits the economic damage. In contrast, a pause would generate concern among financial market participants that the Fed is aware of further shoes left to drop.”

“The old ‘what does the Fed know that we don’t’ adage is cliché, but, in this case, it has validity, since the Fed knows much more about the health of individual banks and the sector as a whole than anyone else in light of its regulatory role. With a hike fairly widely expected, no move tomorrow would risk sending a message that the Fed sees new problems ahead,” Stanley added.