Market Extra: Bond investors confident of Fed rate cut this week, but pare bets on further easing

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If the Federal Reserve cuts interest rate for the third time this year on Wednesday, don’t expect further easing on the cards.

That’s the assessment from bond-market participants who have rolled back their expectations for additional cuts after October due to waning fears around a no-deal Brexit and a U.S.-China tariff spat. But a lack of improvement in the manufacturing sector alongside deteriorating data abroad should still push the Fed to pro-actively ease policy.

“The data is soft enough right now, the Fed wouldn’t be criticized for cutting,” Lori Heinel, deputy global chief investment officer for State Street Global Advisors, told MarketWatch.

But she and other investors say if the central bank does end up trimming its benchmark interest rate, it is also likely to put policy on hold so that senior Fed officials can check if the rate cuts have helped to offset the impact of trade tensions and whether progress towards a U.S.-China trade deal will filter into the real economy.

“The Fed’s persistent narrative that the current easing cycle is a ‘mid-cycle’ adjustment, and the possibility that the Fed will want to gauge the effects of its policy response thus far before further rate cuts, could lead markets to reduce pricing for further cuts on the margin,” wrote Stuart Sparks, a bond analyst at Deutsche Bank, in a research note dated last Friday.

See: Why would the Fed cut interest rates a 3rd time in a row even as stocks near records? Investors may soon find out

Traders in the fed fund futures market where banks can borrow funds overnight from each other now see a 93% chance of the U.S. central bank lowering rates by a quarter point to 1.50%-1.75% at the two-day meeting that concludes on Wednesday.

Read: Fed’s Clarida says economy facing risks while inflation remains muted

Moreover, signs of progress toward a so-called phase one trade deal between the U.S. and China has tamped down on fears that a further escalation of tariffs is forthcoming. And the chances of a no-deal Brexit arrangement has winnowed after U.K. Prime Minister Boris Johnson agreed to a deal with the European Union, even though his proposal has so far failed to pass muster in Parliament.

The improvement in investor sentiment has led to a fading of expectations for an extended easing cycle, even if Wall Street has all but baked in a third rate cut in 2019.

Up to now, bond traders said the central bank would have to give into the growing recession fears and continue to cut interest rates beyond this year. But that dynamic appeared to change as short-dated bond yields sensitive to the Fed’s policy intentions rose sharply during this month’s Treasury selloff, much more so than their longer-term counterparts.

The 2-year Treasury note yield TMUBMUSD02Y, +0.98%  is up nearly 50 basis points from a recent low of 1.368% on Oct. 3, but was last seen trading at 1.858%. Over the same span, the 10-year Treasury note yield TMUBMUSD10Y, +2.95%  has risen by more than 30 basis points to trade at 1.853%. Bond prices move in the opposite direction of yields.

On the flipside, risk assets have shined. The S&P 500 SPX, +0.58%  rose 0.5% to set a fresh intraday record at 3,044.12 on Monday, contributing to a more than 2% gain in September, FactSet data show.

Opinion: Another rate cut, and then what? The Fed isn’t making any promises

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