In a year dominated by worries about inflation and rising interest rates, strategists and traders said a narrative is building within financial markets in which the Federal Reserve will likely need to back off aggressive interest rate hikes soon.
While such a possibility isn’t entirely new, it’s suddenly gained greater credence in just the past few days. On Wednesday, the Bank of Canada delivered a smaller-than-expected, half-percentage-point hike. Then on Thursday, the European Central Bank was seen as opening the door to a slower pace of rate increases after delivering another aggressive, three-quarters-of-a-point hike. That added up to what fed-funds futures traders now see as a slim chance the Fed might back off another aggressive hike as soon as next Wednesday, despite widespread expectations to the contrary.
Read: Euro slips as traders see ECB opening the door to slower rate hikes
Signs of this shift in thinking were evident on Thursday: Treasury yields fell broadly across the board, with rates on 3-
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and 6-month bills
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relinquishing earlier advances during volatile trading. In addition, fed-funds futures pointed to an 11.5% chance that the Fed might surprise markets by delivering only a half-point, or 50-basis-point, rate hike on Nov. 2; this was a startling development considering that The Wall Street Journal, seen as having a direct line to the Fed, reported only a week ago that policy makers were set for a 75-basis-point rate hike.
Even as fed-funds futures traders still clung to an 88.5% chance of a 75-basis-point hike next Wednesday, which would lift the fed funds rate target to between 3.75% and 4%, there was a sense that policy makers might be approaching the end of the road with “how much tightening they can actually do,” said Tom di Galoma, managing director of rates trading at Seaport Global Holdings in Greenwich, Conn.
Indeed, the market-implied odds of an aggressive Fed rate hike in December slipped to 34% on Thursday, down from 75% a week ago, and fed-funds futures traders also pulled back on their expectations for how high rates could go next year, according to the CME FedWatch Tool.
“People are talking about more signs of peak inflation having hit, which is why Treasurys are rallying,” which produces lower yields, “and the implied terminal rate has moved back in from 5% to 4.8%,” said Scott Buchta, the Franklin, Tenn.-based head of fixed-income strategy for Brean Capital.
The market is beginning to think there’s a limit, whether realistic or not, “to how high policy makers can go or want go,” Buchta said via phone on Thursday. “The market is starting to price in that we are closer to the end of aggressive hikes, but we think the Fed is going to keep rates higher for longer than expected.”
With traders now betting that ECB could slow its pace of rate hikes, the euro dipped back below parity against the dollar
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on Thursday. Meanwhile, major U.S. stock indexes
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diverged as investors assessed a raft of data and earnings results.
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