Why is the Bond Market Fighting the Fed?

More than any other people I have ever met, traders love a good cliché. Phrases like "buy low and sell high," "don’t try to catch a falling knife," and my personal favorite, "the market can stay illogical a lot longer than you can stay solvent," are, in my experience, repeated ad nauseam in dealing rooms with large teams. They are quoted in a kind of ironic way, where their constant use moves from annoying to groan-inducing to mildly funny in their own right.

In most cases, though, the repetition is not just about the humor: those sayings serve to remind everyone of simple and basic logic that often gets overlooked. Buy low and sell high reminds us not to get caught up in complex strategies and that trading is, at its core, basically simple; the falling knife aphorism is a reminder to respect momentum; and the comment about logic cautions against pig-headedness and arrogance.

Another cliché that has always been respected for obvious reasons is advice that I was given early in my career in interbank forex: "Don’t fight the Fed." In my case it was "The Old Lady," the Bank of England. Central banks are incredibly powerful in markets. They have just about unlimited resources and a multitude of tools they can use to get their way, so as a general rule, trading in the direction of their stated views and intentions makes a lot more sense than trading against them. Over the last few months, though, the bond market seems to have thrown that particular cliché out of the window.

Even as the Fed has told us constantly and just about unanimously that they will keep hiking rates until there is an obvious impact on demand in the economy, the shorter end of the yield curve has been falling. The yield on the 2-Year, for example, has fallen from a high of just over 4.7% in December to below 4.2% as I write, just a couple of months later.

That suggests a bond market that is betting on not just the Fed slowing and pausing the pace of interest rate increases, but on a complete pivot to actual cuts coming soon. The Fed, however, while acknowledging that a pause will be appropriate at some point, insists that a reversal to rate cuts is not coming anytime soon. So, why are bond traders fighting the Fed?

The most obvious reason is that they neither respect nor believe, and certainly don’t fear, the institution and its Chair, Jay Powell. After all, this is the same Fed Chair who said that inflation was “transient” for months after the data started to suggest otherwise, and continued to resist rate hikes right up until they started. One could argue that Powell accepting reality when he did showed admirable flexibility and a willingness to swallow his pride and do what was best for the economy, but doing that had a price. That price was his credibility.

Traders no longer believe Powell when he says that he will continue hiking rates until the numbers show a significant slowdown in the economy. They believe that, when push comes to shove, fear of getting on the wrong side of the curve again will be stronger than any logical conclusion that a significant slowdown is needed, and Powell will shift gears quickly. He has changed his mind once, the logic goes, so he will do it again.

Bond traders may have lost respect in one way when Powell pivoted, but the market is now suggesting that a “soft landing” is the most likely outcome of the Fed’s efforts over the last year or so. If that is what transpires, then Powell will get and deserve all the respect in the world for navigating such an end-state, and not fighting the Fed will become a thing again.

* In addition to contributing here, Martin Tillier works as Head of Research at the crypto platform SmartFI.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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