Rising Rates Spark Hedging Ahead of Inflation Reading
Investors are now paying a premium to protect themselves from a potential stock market decline, as a key inflation reading due this week is expected to show prices are not moderating as the Federal Reserve would like. This move has caused the cost of contracts protecting against a 10% decline in the largest exchange-traded fund tracking the S&P 500 to be 1.7 times more than options that profit from a 10% rally, the highest level since August 2022.
The worst week in 2023 for the Treasury market saw investors coming to grips with the idea that the Federal Reserve may indeed have to keep rates higher for longer as it wages a war against inflation. Bonds around the world continued to decline, as a number of policy makers indicated to investors that more rate increases should be anticipated, dispelling the notion that central banks were close to finishing their tightening cycles. Treasury 10-year yields climbed to around 3.75%, with interest-rate options activity Friday including a large, apparently new position that will profit if the rate reaches 4% within a week’s time. This caused the tech space to underperform major gauges, with the S&P 500 posting its worst week since December.
US Treasuries continued their decline from Friday, as investors increased their speculation about future rate hikes, with the Fed's upper bound of the Fed Funds target rate now being estimated at 5.25%, the highest it has been since November. This shift higher in rate expectations caused the two-year yield to rise 19 basis points to 4.48%, and the five-year yield to rise 17 basis points to 3.83%.
Meanwhile, Wall Street has recalibrated bets on the Fed’s peak rate to around 5.2%, with traders now pricing over 30 basis points of rate cuts by year-end, according to swaps tied to central bank meeting dates. German and Italian notes erased all the gains they made after last week’s European Central Bank and Fed policy decisions, as officials have been busy walking back their dovish messaging.
That’s why Tuesday’s consumer price index is seen as a litmus test for the Fed’s ability to knock down inflation. Investors are now biased for an upside surprise versus the consensus for core-CPI of +0.4% on a monthly basis. Traders who are being cautious are finally increasing their hedging activities as a response to the risk rally that was occurring without considering the Fed's more conservative stance.
0. “What Is US Inflation Rate? CPI, Economic News: February, 2023” Bloomberg, 12 Feb. 2023, https://www.bloomberg.com/news/articles/2023-02-12/it-s-too-soon-for-stock-investors-to-call-victory-on-inflation
1. “Wall Street Sees Worst Week of 2023 on Fed Jitters: Markets Wrap” Yahoo Canada Finance, 10 Feb. 2023, https://ca.finance.yahoo.com/news/asia-stocks-face-pressure-rates-233833830.html
2. “Bond traders ramp up U.S. Fed bets in 2023's worst week” BNN Bloomberg, 10 Feb. 2023, https://www.bnnbloomberg.ca/bond-traders-ramp-up-u-s-fed-bets-in-2023-s-worst-week-1.1881887
3. “Bonds Tumble as Central Bankers Hammer Home Hawkish Message” Yahoo! Voices, 6 Feb. 2023, https://www.yahoo.com/now/bonds-tumble-central-bankers-hammer-220934200.html
4. “EUR/USD retreats from 1.0800 as Fed pause bets fade post mammoth US NFP report” FXStreet, 5 Feb. 2023, https://www.fxstreet.com/news/eur-usd-retreats-from-10800-as-fed-pause-bets-fade-post-mammoth-us-nfp-report-202302052210
5. “Bonds Tumble as Central Bankers Hammer Home Hawkish Message” Financial Post, 7 Feb. 2023, https://financialpost.com/pmn/business-pmn/bonds-tumble-as-central-bankers-hammer-home-hawkish-message
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