Draghi Could Cripple One of the Hottest Trades in U.S. Rates
Mario Draghi’s last act at the helm of the European Central Bank could be the beginning of the end for a massive consensus trade on U.S. interest rates.
Bets on Federal Reserve easing are at all-time highs, according to speculators’ latest positioning in short-term rates. But that vision for at least a half-point of U.S. cuts this year — backed largely by a conviction that central banks globally will unleash more stimulus — looks dicey after policy makers in Sweden, Canada and Australia pushed back last week.
Doubts that the ECB will do all that’s expected of it on Thursday have helped push government yields on both sides of the Atlantic up from multiyear lows in recent days. That could be the beginning of a sweeping recalculation for those heavily invested in central banks taking action to prevent a recession.
It appears likely that the Fed will next week cut rates by 25 basis points for the second time in 2019, but that looks unwarranted by U.S. economic data. And Jerome Powell’s Fed looks more divided. While the decisions to hike rates nine times between 2015 and 2018 and pause early this year were unanimous, two voters dissented on the July cut. Further action may be harder to justify if the biggest fears driving defensive flows around the world — the U.S.-China trade dispute, Brexit and Hong Kong’s protests — dissipate.
“You’ve had a number of central banks and central bankers pushing the other way,” said Mark Dowding, chief investment officer of BlueBay Asset Management, which oversees more than $60 billion. “In ordinary times, one would question whether the Fed would be thinking about cutting rates at the minute given that the outlook for the U.S. domestic economy is pretty healthy.”
Data from the U.S. Commodity Futures Trading Commission released Friday showed speculative positioning across eurodollars — the corner of the market most sensitive to immediate policy action — is at record net-long levels.
But there are signs things are shifting. Traders in fed fund futures are now pricing in two Fed cuts between now and Dec. 31. Last month, three were almost fully factored in. Swaps tell a similar story, as do eurodollar futures, which just saw an aggressive sell-off amid reduced expectations for another ECB asset purchase program. Options traders are bracing for disappointment, snapping up hedges this week to protect against a scenario where the Fed cuts less than is priced in.
As markets prepare for a series of unpredictable events, some investors are taking to heart the comments from Fed Vice Chairman Richard Clarida, who managed to temper expectations somewhat last month at the central bank’s annual gathering in Jackson Hole, Wyoming.
He reminded markets that the Fed is balancing the global and domestic risks as they unfold, and taking “our policy decisions one meeting at a time.” Fittingly, that comment was soon overshadowed by the turmoil that followed President Donald Trump’s tweet announcing more tariffs on Chinese goods.
“I believe Clarida when he says they’re going to take this one meeting at a time, they’re going to be data-dependent, but also trade war-dependent,” said Kristina Hooper, chief global market strategist at Invesco Ltd., which has close to $1.2 trillion under management.
Yields on 10-year Treasuries have reversed more than a third of their massive August drop, leaving them at 1.71% Tuesday. The two-year hit the highest level in a month on Tuesday. But it’s hard to imagine rates rebounding much more while central-bank policy remains accommodative and markets are gripped by uncertainties over trade policy and the health of the global economy.
To J.P. Morgan Asset Management’s David Kelly, a less-than-dovish ECB statement can keep yields from plumbing fresh lows. But the bigger move higher will be a more gradual process, he said, and probably not truly underway until global trade tensions are resolved, most likely not before the 2020 U.S. presidential election.
“Longer term, we will see higher yields both in Europe and the U.S.,” said Kelly, the chief global markets strategist at the $1.7 trillion asset manager. “There’s an awful lot of psychology and not a lot of rationality in the way that global bond yields are being set right now.”