Early on the morning of October 14, hours before the closely watched U.S. inflation report was released, TD Securities' Gennadiy Goldberg advised clients to bet that the Federal Reserve would not raise rates later that month, reasoning that inflation could be mild enough to justify keeping rates unchanged.
Just as important, several Fed officials had spent days trying to dispel market expectations that the Fed was about to raise rates soon. The data that followed came in hot, and traders quickly ramped up their bets on an October hike, at one point pushing the probability to around 50%, compared with roughly 20% before the report was released.
Goldberg and his team began discussing whether to abandon the trade they had just established. Yet market moves reversed almost immediately, and by the close most of the day's yield gains had been erased. "We didn't even get a chance to reposition," said Goldberg, head of U.S. rates strategy.
That day, a mix of market factors combined to drive volatility in the bond market, including a stock selloff, turmoil in artificial intelligence shares and tensions in France. But for many, what ultimately fueled the move was a series of Fed remarks signaling a pause in October.
That seemingly explicit language was especially striking, particularly since Fed Chair Kevin Warsh had said he wanted to free the market from this kind of "forward guidance."
Traders caught in a dilemma returned to a familiar strategy and paid close attention to policymakers' comments. But they also acknowledged that the inflation data alone might have been enough to justify betting on an October hike.
All of this has left investors on edge ahead of this week's policy meeting, still somewhat uncertain and vulnerable to heavy losses if they misjudge the situation.
"There is a disconnect between what Warsh says and the signals everyone else is sending," said Neil Dutta, chief economist at Renaissance Macro Research. "When you get that kind of development or situation, the market always faces the risk of sharp swings at any meeting."
Admittedly, recent market developments have reduced the likelihood of such sharp swings. As AI stocks continue to slide and concerns grow that a slowdown in the AI boom would weigh on U.S. economic growth prospects, traders are now even less convinced that the Fed will raise rates this week or even this year. According to interest rate swap data, the probability of an October hike is now below 15%.
But just weeks ago, when the wave of speeches began, the market looked very different. The backdrop was a brutal bond selloff that sent U.S. bond yields sharply higher. The Fed raised rates in September for the first time in three years, and the market at the time expected another hike in October and possibly more in December, as investors anticipated the Fed would act to curb inflation that remained above target.
Brakes
On September 29, New York Fed President John Williams said in a speech that one more rate increase later this year might be appropriate. Federal funds futures contracts showed the remarks prompted traders to cut the odds of an October hike to about 50% from 70%.
Two days later, on October 1, Fed Vice Chair Philip Jefferson made a similar point, suggesting policymakers should take more time before deciding whether further tightening was needed, a view that pushed market-implied odds of a hike down further to around 25%.
Fed Governor Christopher Waller said in an October 8 speech that officials did not need to tighten policy at consecutive meetings, remarks sufficient to cement market expectations.
"I think they were looking at the bond market and saying, 'Wow, the market is pricing in much more tightening than we expect,'" Nationwide chief economist Kathy Bostjancic said of the Fed officials' remarks. "So I think it made them uncomfortable, and they said, 'Okay, let's slow down.'"
By the time inflation data showed prices rising at the fastest pace in five months, investors had already formed entrenched expectations, with most anticipating rates would stay unchanged. Bostjancic put the odds of a hike at close to a coin flip, while others held stronger views.
"The data support a hike," said Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle. "The only swing factor between a hike and holding rates steady is the Fed's wording."
Warsh himself stressed during an appearance in Bangkok on October 16 that he would not prejudge the outcome of any meeting. Speaking on a panel at the International Monetary Fund's annual meetings, he said, "I don't think it's appropriate right now to talk about what I might do at upcoming meetings this year. The Fed has turned a new page, and we are no longer conducting business the way we used to."
Even so, what traders focused on was that, beyond reiterating his commitment to "price stability," the Fed chair did nothing to dispel market expectations that the central bank would refrain from action this week, even after the inflation data was released.
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