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What the bond market’s action this week says about expectations for Jackson Hole

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The bond market has mostly been selling off this week — and interest rates have been going higher and higher — as market pros expect a hawkish Fed chairman at Jackson Hole Friday morning. That bet has helped drive the benchmark 10-year Treasury yield sharply higher. Bond market pros say anticipation of a tough-talking Jerome Powell has investors selling bonds on expectations of a higher interest rate world. Yields are also getting a boost from an improved view of the economy. The 10-year yield was flattish Thursday morning after rising on improved jobless claims data and a positive revision for second quarter gross domestic product to negative 0.6%. Before slipping back, the yield was as high as 3.12%, the highest since late June and well above its early August low near 2.50%. The 2-year yield, which most reflects Federal Reserve policy, continued to rise and was at 3.38% Thursday. “I think this latest move over the week so far has been some reflection of a hawkish Powell — or at least not a dovish Powell,” said Ben Jeffery, an interest rate strategist at BMO Capital Markets. He said the 10-year yield broke key technical levels this week at 3% on Monday, and again at 3.09% on Wednesday. Yields move opposite price. “There’s generally speaking not a ton of willingness for people to step in front of this until Friday,” said Jeffery. The 10-year is closely watched, since it is the rate that influences mortgages and a variety of consumer and business loans. There are some key points that investors are hoping Powell will clarify. First, the market is debating whether the next rate hike, expected Sept. 21, will be 50 basis point or 75 basis point increase. At this point, traders in the fed funds futures market put higher odds on a three-quarter point hike, which would be the third in a row after similar size hikes in both June and July. As of Wednesday morning, the futures market was pricing in 65 more basis points in hikes by October, said Jeffery. That would suggest market pros are leaning toward a 75 basis point hike. A basis point equals 0.01 of a percentage point. The Fed has already raised the fed funds rate range to 2.25% to 2.5%, from zero to 0.25% in March. The next question is what level does the Fed want to reach before it stops raising rates. As of June, its forecast put the terminal, or end rate at 3.50% to 3.75%, and that is what the market is currently pricing. “At this point, the bar is high for him to be hawkish. The bar is low for him to be dovish,” said Jim Caron, head of macro strategies for global fixed income and Morgan Stanley Investment Management. Caron said the most important comments from the Fed chair would be around what officials believe the terminal rate should be and how long it should stay there. “My take is there’s been a big misinterpretation of what Powell said in July,” said Caron. After the Fed’s July meeting, the market perceived the potential for the Fed to “pivot” away from its rate hiking strategy in the back half of next year and even begin to cut rates. “The prepared comments that he and the Fed has officially made have been very consistent with the Fed going to 3.5% to 3.75% by the first quarter of next year,” said Caron. “The markets all of a sudden started to price a reversal in the fed funds rate and that took down the 10-year yield.” Fed officials went on the offensive this month to change the market view. St. Louis Fed President James Bullard, for instance, pushed the idea of a 75 basis point hike for September . San Francisco Fed President Mary Daly said the Fed should raise rates and hold them there. Caron said the market view has backed away somewhat from the idea of Fed rate cuts in 2023, but there is still a quarter point reduction priced in to fed funds futures for the second half of next year. The 10-year yield, meanwhile, has had a pretty quick run back above 3% on hawkish expectations for Jackson Hole. “All we’re doing is rewinding the clock back to July,” said Caron. Investors had feared the Fed’s rate hiking was going to push the economy into a recession, but strong employment data in July and a decrease in the pace of inflation has helped temper that concern. Caron said “one of the cornerstones” of Powell’s “dovish pivot” was him saying we’re at 2.5%. “We think we’re pretty close to neutral,” he said, explaining that some market participants took Powell’s comment to mean the Fed was nearly done with rate hikes. But Caron said that 2.5% is not a new number for the neutral rate, which is the level where the Fed neither has to tighten or loosen policy. “That’s just boiler plate.” The Fed’s message has been clear in that it is determined to bring down inflation, and Powell may emphasize that the Fed is not planning to cut rates and that it will keep its guard up against inflation by holding rates at higher levels. Cindy Beaulieu, portfolio manager at Conning, an institutional asset management firm, said she expects Powell to try to sound more hawkish. “I think it’s an uncomfortable place for him to be. He tries to stay on the neutral path as much as he can,” she said. But Beaulieu said she expects Powell will emphasize that the Fed will remain diligent, and that it’s data dependent. “I think the market is going to be looking for clarification from Chair Powell on Friday from what has been perceived as a more dovish tone, to make sure the market knows that despite a more decent print for inflation for the July data in August, there’s still a battle to be fought from the Fed’s perspective,” said Beaulieu. Bond strategists say yields could keep going higher if Powell is hawkish but based on the market’s tilt, there could be a bigger market reaction if he is dovish. A dovish Powell could also spark a stock market rally. “I think he’s going to come out and say exactly what he said in June and exactly what he said in July and the markets are going to take that as dovish,” said Caron. The Fed’s message will be very important for markets, Caron said, particularly whether it plans to go beyond the current neutral rate and how long it plans to hold there. “That is what the market is looking at going into Friday and what we’ll be talking about over the weekend and into Monday and Tuesday,” he said.

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