“Mid-cycle adjustment in policy.”
In one fell swoop, Federal Reserve Chairman Jerome Powell dealt a sharp blow to one of the bond-market’s most popular trades at the Fed’s post-meeting press conference after the U.S. central bank cut interest rates by 25 basis points on Wednesday.
For much of the year, investors have successfully bet that the gap between short-dated and long -dated yields would widen, steepening the yield curve, amid expectations for easier Fed monetary policy.
But Powell’s remarks suggesting the Fed’s cut in July would be more of an insurance move against an economic slowdown led the yield curve to flatten instead. His comments came as a surprise to the crowd of Wall Street investors and traders who had hoped for the Fed to deliver on the market’s dovish expectations.
“The yield curve steepened initially but then flattened on Powell’s comment about the rate cut being a “mid-cycle adjustment”. It looks like he caught many traders on the wrong side of the steepening trade,” said Kathy Jones, chief fixed-income strategist at Schwab Center for Financial Research.
Recently, strategists at Bank of America Merrill Lynch, Deutsche Bank and BMO Capital Markets have all favored yield-curve steepening trades that simultaneously buy short-term Treasurys and sell longer-term debt.
The yield spread between the widely-watched 2-year TMUBMUSD02Y, +1.51% and 10-year note TMUBMUSD10Y, +1.38% narrowed by 7.6 basis points to 13.8 basis points on Wednesday, according to Dow Jones Market data. This marked the biggest daily flattening since late 2016.
Biggest one day flattening in 2s10s since the tail end of 2016 pic.twitter.com/oZ4zEyKIzs
— Luke Kawa (@LJKawa) July 31, 2019
Most bond traders had expected the Fed to cut interest rates by 25 basis points and signal further cuts down the road, but Powell’s mixed communications undermined the Fed’s policy statement by suggesting the U.S. central bank was more concerned about global economic growth slowing than the health of the U.S. economy.
“The market was near-unanimous on a 0.25% rate cut, but the market reaction is clear that the outlook is nowhere near dovish enough,” wrote Tom Garretson, a fixed-income strategist at RBC Wealth Management.
Later in his press conference, Powell tried to undo the hawkish message of his comments by saying, “What I said was it’s not the beginning of a long series of rate cuts. I didn’t say it’s just one,” he said.
Yet by the end of the day, the damage had already been done.