Orlando – The Wall Street recession and the rebound in the US bond market point to a growing belief that the recession is on the horizon, easing the Federal Reserve’s tight cycle as soon as it wants to and opening the door to rate cuts next year.
Hedge funds are also seen to be betting, according to the latest Commodity Futures Trading Commission report on rate futures positioning.
Data for the week of May 17 shows that speculators have reduced their net short positions in the three-month Secured Overnight Financing Rate (SOFR) agreement in almost two months and maintained their net long positions in 30-day Fed Fund futures.
SOFR reveals the most volatile futures positioning, especially in light of the broader trends in that market, one of the most accurate barometers of traders’ outlook on US interest rates over the next few years.
The funds reduced their net short-term three-month SOFR position to 388,207 contracts from 460,721 weeks ago. This is the shortest net short in seven weeks, and significantly down from the record of more than 600,000 contracts just a month ago.
The shift to the long position, rather than a short cover, has almost completely come down, suggesting that traders are starting to look beyond the aggressive tug-of-war this year towards possible facilitation next year.
A short position is basically a bet that the value of an asset will decrease, and a long position is a bet that it will increase. At a rate, when prices rise, implied yields decrease, and when prices fall, prices rise.
Fed officials have insisted they will continue to tighten policy until they feel their inflation targets are being met despite economic “pain”. Traders in the SOFR market and funds are putting more of their eggs in that “pain” basket.
Rates are seen to be low starting next year
First, the implied rate for the next year is rapidly declining. The June 2023 agreement now refers to a Fed funding rate of about 3%, about half a percentage point lower than the day the Fed raised its 50-basis point rate on May 4.
Second, the expected length of the Fed’s tightening cycle has been dramatically shortened. A few months ago, traders expected the Fed’s ‘terminal rate’ to reach September next year. It moved to June, but is now on the March table.
The implied rate in December 2023 SOFR futures fell to 2.80%, the lowest in almost 2 months. Set against the June high terminal rate forecast, which indicates an 80% chance of the Fed lowering rates in the second half of next year.
Even St. Louis Fed President James Bullard, who wants to raise the rate to 3.5% this year, says the Fed could cut them early next year if inflation stays under control.
Fed officials and most economists still say there will be no recession. But the financial situation has begun to tighten sharply – Wall Street is in turmoil, and Citi’s U.S. economic surprise index is now negative and at a five-month low.
Analysts at Deutsche Bank wrote on Friday that “we expect that the tightening of financial conditions initiated by the Fed policy will probably lead to a recession by the end of 2023.”
Wells Fargo’s research arm joined Deutsche Welle last week to forecast the US recession, but even earlier, later this year.
– Markets could be more ugly if Fed is chosen (Reuters, May 20)
– Fed fingers crossed for 1994 as hiking paths shortened (Reuters, May 5)
(The views expressed here are those of the author, a Reuters columnist.)
(By Jamie McGuire; edited by Sam Holmes)