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Why the Fed is the key to mixed bond market signals

Bonds 5 minutes to read
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Today's Federal Open Market Committee meeting is critical for investors , given the huge influence of Fed policy on asset valuations worldwide. But what should bond investors watch out for in particular?

This week is a busy one with 14 central banks making monetary policy decision. The lion’s share of the bond market’s attention will go to the US Federal Reserve, where traders from around the world are looking to understand whether their positioning on corporate bonds and emerging markets was the right course of action amidst sluggish global economic growth.

The financial market is giving us conflicting messages: both the bond market and the equity market have been rallying since the selloff in equities at the end of last year. The yield on the 10-year Treasury yield, long regarded as a safe haven, has been falling from its high of 3.2% at the beginning of November to 2.55% at the beginning of January; since then it has been trading rangebound with a tendency to the bottom of the channel. 

In the meantime, the S&P has risen 16.5% from the beginning of the year, leaving many to wonder whether the bond market knows something that equities don’t. 

The rally seen since the beginning of the year was provoked by a radical pivot from hawkish to dovish at the word’s major central banks. The chart below shows that the rally began in earnest on January 4, when Fed chair Jerome Powell said that the Fed will be patient with monetary policy, suggesting that will not continue to hike interest rates at the pace outlined a month earlier.
Source: Saxo Bank
Fed policies do not only drive the valuation of dollar-denominated debt, but also support the valuation of risky assets worldwide, such as emerging markets and lower-rated corporates. This is why today’s Federal Open Market Committee meeting today is receiving so much attention. A dovish Fed means the difference between resilient markets and a widespread sell-off that hits the weaker parts of the economy disproportionately.

Today, we expect the Fed to keep interest rates unchanged until data show that the macro environment is well supported. The element of surprise this week concerns possible news on the ending of the balance sheet runoff. We believe that the Fed will take some time before revealing when is going to terminate its quantitative tightening, as that could provoke a contained sell-off in equities, EM and corporate bonds. However, if it decides to outline a plan to end its balance sheet runoff, we may witness to a last push higher in equities, EM and credits.

It has not been easy for fixed income investors to find buying opportunities in the credit space of late, but if the Fed does not announce the end of QT, or if the announcement is disappointing, this might me the perfect time to buy bonds amid a contained sell-off. 
We believe that with central banks staying supportive of the economy (against a looming recession threat), quality bonds will continue to rise in value; lower-rated credit, meanwhile, might rise in the short-term, but will be doomed to sensibly reprice as a recession approaches. 

This is why we recommend investors remain cautious and not take on unnecessary risk unless the fundamentals look particularly promising. But what should if the Fed is complacent regarding market expectations and outlines and end of QT, boosting asset valuations?

US two-year Treasury notes are trading at 2.45%, 5 basis points lower than the Federal Reserve benchmark rates, suggests that the market is indeed positioned for a more dovish message. Thus, current credit spreads could be poised to tighten further from here.
If this is the case, investors will have their hands tied as current valuations will most likely rise until the economy begins to enter into a recession. Still, this should not be an excuse to refrain from putting one’s money to work, particularly when the US yield curve offers good returns. Even parking some money in one- and two-year maturities will return more than 2%, and in the meantime investors will have all the time in the world to make up their minds.

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