On Sunday, the US administration took emergency steps to shore up banking confidence, guaranteeing deposits after withdrawals overwhelmed Silicon Valley Bank and closing under-pressure lender Signature Bank in New York.
Anticipating that the Federal Reserve will be reluctant to hike next week while the mood is feverish and delicate, bond markets rapidly repriced interest rate expectations.
By 1053 GMT, futures pricing implied just a 50% chance the Fed will hike borrowing costs by 25 basis points next week – a huge shift from last week when markets briefly bet a 50 bps move was more likely.
“We have a big data print tomorrow with CPI (inflation) and unless market turmoil really continues and leads to a tightening in financial conditions, then the Fed will do 25 bps,” said Mark Dowding, chief investment officer at BlueBay Asset Management.
“If rate hikes are starting to bite then you do have to proceed with more caution.”
In Europe, traders dialed back bets the European Central Bank will hike its interest rates by 50 bps on Thursday as it has indicated, and now see a 25 bps hike in May as more likely than a 50 bps move.
Markets also moderated their view on UK rates and were pricing in a roughly 75% chance of a 25 bps hike when the Bank of England meets next week.
All of that helped extend a rally in shorter-dated bonds on Monday, putting two-year Treasuries on course for their best three-day gain since 1987.
Banks also adjusted their forecasts. Goldman Sachs said on Sunday the banking stress meant it no longer expected the Fed to hike rates next week.
Two-year US Treasury yields were last down 30 basis points and have fallen 75 bps since Wednesday.
At 4.30% they are also below the bottom end of the Fed funds rate window at 4.5% – a sign markets see a peak is near.
“I think people are linking Silicon Valley Bank’s problems with the rate hikes we’ve already had,” said ING economist Rob Carnell.
“If rates going up caused this, the Fed is going to mindful of that in future,” he said. “It’s not going to want to go clattering in with another 50 (bps hike) and see some other financial institution getting hosed.”
terminal slide
Monday’s moves also pulled sharply forward and pushed down market expectations for where rates will peak.
US rates are now expected to reach a high of around 4.9% in June, down from around 5.7% on Wednesday.
That is followed by a 60% chance of 50 bps of rate cuts priced in by December, a huge drop from the 5.5% priced for year-end last week.
Traders also brought down bets on where ECB borrowing costs will peak, to around 3.5% in November, down from around 4.1% last week.
“There’s going to be much more emphasis on the risks to the outlook from Lagarde on Thursday than if SVB hadn’t happened,” said Danske Bank chief analyst Piet Christiansen.
“So I think the risks are definitely bigger now than before,” Christiansen said, although he maintained his forecast for a 4% peak ECB rate.
The size of the shifts drew warnings from analysts who said they reflected poor liquidity in markets and could be unwound quickly, especially if Tuesday’s US inflation data is strong.
Long-dated bond yields also dropped much less than shorter-dated peers, with inflation being a greater risk if hikes were to slow or stop.
“If anything, support for deposit holders supports the idea that the Fed could keep tightening policy,” said Jack Chambers, senior rates strategist at ANZ Bank in Sydney.
A new Fed bank funding scheme aimed at addressing some of Silicon Valley Bank’s apparent problems with losses in its bond portfolio is expected to further help with stability for banks and bonds.
Banks will now be able to borrow at the Fed against collateral such as Treasuries at par, rather than market value – greatly reducing any need for banks to liquidate bonds to meet unexpected withdrawals.
