Investors bracing for another Federal Reserve interest rate hike are focusing on a few key trades: betting on a deeper inversion of the U.S. yield curve, further equity losses and a stronger dollar.
Short-term Treasury rates have outpaced yields at longer maturities for months, in a proven harbinger of an economic downturn to come. The MLIV Pulse survey, which drew 737 responses, showed that the majority of contributors expect another reversal. Some see it reaching levels last seen in the early 1980s, when Paul Volcker raised borrowing costs to break the back of hyperinflation.
This outlook underscores the rise of bearish sentiment amid fears that the central bank could stifle growth in its fight against inflation. Most economists are expecting a third consecutive 75 basis point increase on Wednesday, with further tightening to come. The majority of contributors to the MLIV survey say it is better to bet on dollar gains, and 44% prefer to sell stocks.
“The strong message from the Fed is that they want to cause demand destruction by pushing rates higher, so it’s not a question of if we go into a recession but when,” said Subadra Rajappa, chief executive. of the US rates strategy at Societe Generale SA. “And there’s a good chance we’ll have a hard landing-type situation.”
Warmer-than-expected consumer inflation data last week boosted expectations about how hawkish the Fed needs to be to rein in price pressures. That prompted traders to see the Fed raise its benchmark to a high of around 4.5% in March, from a current target of 2.25% to 2.5% for the fed funds rate.
It’s a perspective that sets the stage for the yield curve to invert more deeply. Investors can make this bet by selling short-term Treasury bills and simultaneously buying longer maturities. While survey respondents expect yields to rise across the board, they see shorter-term rates — those most closely tied to Fed policy — climbing further.
It’s a typical pattern when the Fed withdraws its accommodative measures, and it’s already pushed the widely-seen spread between 2- and 10-year yields to minus 58 basis points last month, the most inverted since 1982. With 446 investors expecting a deeper reversal, 62% see this spread sinking even deeper into negative territory, while 38% expect it not to break above last month’s low.
These measures are worth watching because of their track record: the spread between three-month bill rates and 10-year yields reversed before each of the last seven US recessions.
“The bond market expects the Fed to raise rates enough to trigger a recession,” said Kathy Jones, chief fixed income strategist at Charles Schwab.
The prospect of an earnings-crushing recession combined with higher borrowing costs provided a key survey result for equities. Stocks are emerging from another painful week, reflecting growing fears that the Fed’s aggressive rate-hike campaign could dampen economic growth. The S&P 500 index fell 4.8% on the week, while the tech-heavy Nasdaq 100 fell 5.8%.
The largest share of survey respondents, 44%, said they were selling stocks ahead of the Fed meeting. Granted, the latest stock plunge has left some investors concluding it’s time to buy: 28% say they’re buying value stocks ahead of the Fed, 16% say they’re long on all stocks, and 13% prefer growth stocks. .
“It will be another hawkish message from the Fed,” said Michael Contopoulos, director of fixed income at Richard Bernstein Advisors. “And the one quadrant you don’t want to be in if you’re an equity investor is where earnings growth is slowing and monetary conditions are tightening, and that’s where we’re going.”
Yields and dollar
One of the strongest signals from the survey is that respondents still see pain for the roughly $24 trillion U.S. Treasury market, which is already on track for its biggest annual loss since. at least the early 1970s.
The majority of respondents, 70%, said they expect 10-year Treasury yields to be higher in a month than they are now, compared to 30% who expect them to fall .
That benchmark for global borrowing has already more than doubled this year, to over 3.4% now, raising borrowing costs for everyone from businesses to homebuyers.
One of the biggest winners from rising yields could be the dollar, which has soared this year as the Fed’s tightening campaign inflated interest rate differentials in favor of the greenback.
“It keeps the US dollar supported,” Charu Chanana of Saxo Capital Markets said in an interview with Bloomberg TV.
Among MLIV Pulse respondents, 61% said there was more upside for the greenback, signaling that it is better to maintain or increase long positions.
The Bloomberg Dollar Spot Index, which tracks the currency against a basket of 10 major counterparties, set a record high this month. The greenback’s strength ripples through global financial markets, putting pressure on U.S. trading partners, including Canada and Japan.
Fed Chairman Jerome Powell said this month that officials “must act now, frankly, strongly” to rein in inflation. In the eyes of survey respondents, this likely means little deviation from this year’s major investment trends.
“The Fed is fighting a battle against expectations,” wrote Joe Davis, chief global economist at Vanguard Group Inc., in a research note. “It’s a trade-off between the impacts of higher policy rates, but they’d rather rein in inflation in the current environment, even at the expense of growth and the labor market.”