The U.S. Treasury market, teetering on the brink of a third consecutive year of losses, is keenly awaiting the Federal Reserve’s updated forecasts for their benchmark interest rate this Wednesday. The projections, known as the “dot plot,” have gained considerable significance in light of the Federal Reserve officials’ reticence to provide specific verbal guidance about policy outlook.
The policy meeting scheduled for September 19-20 is particularly crucial, with widespread expectations that the Fed will maintain its current rates. Discussions are likely to center around the duration of these rates.
The dot plot is expected to shed light on two key questions: whether policymakers will stick to their expectation of a further 25 basis-point rate hike by the end of this year, and what degree of easing they foresee for 2024. As of June, they had projected cuts amounting to 1 percentage point.
The recent release of the consumer price index (CPI) has complicated officials’ decision-making process. Despite softer CPI gains in recent months, the core monthly gain — excluding volatile energy and food items — accelerated in August. This report may have bolstered a majority of Fed policymakers’ inclination to keep one more 2023 hike on their agenda and potentially lean towards three cuts in 2024, rather than four.
Concerns that the Fed might sustain higher rates for longer periods have prompted a decrease in the bond market’s own predictions of rate reductions for 2024. Swaps contracts tied to Fed decisions now reflect about 100 basis points of cuts, down from over 150 basis points earlier this year. Traders predict that the effective federal funds rate, currently at 5.33%, will fall to around 4.49% by the end of 2024.
If policymakers maintain a median forecast for one more hike in 2023 and decrease rate cuts for 2024 this week, two-year Treasuries could potentially be sold off. This could disrupt some investors’ expectations for a steeper yield curve, i.e., a reduced premium for two-year yields over 10-year ones.
As of last Friday, two-year yields were over 5%, nearing the 16-year high seen in July. Ten-year yields were above 4.3%. The curve has been inverted since mid-2022, signaling the Fed’s most aggressive tightening campaign in decades and expectations for an economic downturn.
Some market observers expect the dot plot to reflect only 75 basis points of rate cuts next year, which could prompt the market to adjust its expectations for the Fed’s future actions.
Another key Fed projection to monitor on Wednesday is policymakers’ median estimate for their policy rate over the long run, which has stood at 2.5% or lower since 2019. These forecasts are expected to provide initial insights into 2026, offering investors additional long-term perspectives.
The five-year overnight index swap rate, traded five years forward and viewed as a market proxy for the Fed’s long-run rate, currently stands around 3.72%, up from below 3% in May. This indicates that investors envision the Fed reducing its rates only down to 3.5% over time.
This outlook could pose problems for the overall market, which has just reported its fourth consecutive month of losses. This stagnation represents a significant setback for investors who suffered a record-breaking loss of 12.5% last year — an unprecedented drop in annual data dating back to the early 1970s.
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