Fed Charge Reduce via Yr-Finish Again in Choose as Banks Are Roiled

(Bloomberg) — Bond traders lost no time re-instating bets that the Federal Reserve will cut interest rates before the year is out.

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As recently as Wednesday, a half-point rate hike this month was viewed as likelier than another quarter-point hike, and a rate cut later this year was counted out. With rising borrowing costs subsequently taking the blame for the year’s first bank failure, pricing of swaps linked to Fed meetings shifted Friday to levels suggesting the central bank’s policy rate will peak at around 5.4% in July, but end the year around 5.1% — more than a quarter point lower.

An expected peak of around 5.7% in September was reached after Fed Chair Jerome Powell seemed to open the door to a re-acceleration in the pace of rate hikes in congressional testimony Tuesday. The collapse of SVB Financial, a Santa Clara, California-based bank holding company, sparked a reckoning.

Fed officials “do have to pay attention to this because something is apparently starting to break, and they have raised rates a lot,” said Tony Farren, managing director at Mischler Financial Group Inc. “The reaction to Powell was way too aggressive.”

Meanwhile, the two-year Treasury yield was on track for its second-straight drop of more than 20 basis points. It fell as much as 29 basis points to 4.58%. Its current 36-basis-point drop over two days is bigger than any since 2008.

In the fallout from Powell’s comment, the two-year yield climbed to 5.08% on Wednesday, the highest level since 2007, setting the stage for a snap-back as bets on a deeper selloff accumulated.

The spark occurred Thursday, when SVB Financial blamed higher interest rates as it took unsuccessful steps to shore up capital, on Friday becoming the first federally insured institution to fail this year. To varying degrees, shareholders punished the entire banking sector. Financial companies in the S&P 500 are down about 7% as a group on the week, leading the benchmark to a 3.4% drop.

“It appears that the fear of a hard landing is starting to be built back into rate expectations,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management. “Bank stress may be seen as a sign that monetary policy is working to tighten conditions, albeit with a lag.”

Longer-dated Treasury yields also declined by at least 10 basis points Friday, aided by mixed February employment data seen as lessening the need for the Fed to re-accelerate.

Swap traders now see a 25-basis point hike at the March 22 policy meeting as more likely than half-point move, which was given odds as high as about 75% earlier in the week.

With short-term yields leading the declines, the Treasury curve steepened. At 4.64%, two-year yields were 94 basis points higher than 10-year rates. The gap between the two exceeded 100 basis points earlier this week for the first time since 1981.

–With assistance from Elizabeth Stanton.

(Updates yield levels.)

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