The Federal Reserve, Jerome Powell, testified during a Senate Banking Committee hearing on the “Quarterly Report of the CARES Act to Congress” at the Capitol in Washington, USA, on December 1, 2020.
Susan Walsh | Reuters
The rise in bond yields and the accompanying inflationary fears are adding a level of drama to the presentation by Federal Reserve President Jerome Powell this week before Congress.
The central bank president is expected to address Senate and House panels on successive days as part of the mandatory half-yearly updates on monetary policy.
Normally routine issues, recent financial market turmoil and concerns about how the Fed might react, prompted investors to pay a little more attention than usual at Tuesday and Wednesday hearings.
“This is one of the most interesting episodes that a Fed chairman has had to witness,” said Nathan Sheets, chief economist at PGIM Fixed Income. “Sometimes we say, ‘ho hum, no news’. This is going to be new. It really is caught between a rock and a hard place. “
What caught the market’s attention recently was an acceleration in government bond yields, particularly further down the curve.
While the 2-year term remains unchanged for 2021, the 5-year term increased by almost a quarter of a percentage point at Friday’s market close, while the 10-year benchmark saw its yield jump 41 basis points to 1.34 %, an area where not since the same time in 2020, before the worst of the pandemic.
Yield on 30-year bonds rose further, jumping almost half a point this year to 2.14%.
Powell’s dilemma is this: the increase in bond yields may be signaling the economic downturn that the Fed has been pushing and are therefore higher for good reasons. However, if the trend gets out of hand, the Fed may have to tighten policy more quickly than the market expects, offsetting some of the good that came with the boom in yields.
To complicate matters, markets may also dislike it if Powell is overly complacent.
“If that testimony were behind closed doors, I think Jay Powell would be very pleased with what he sees in the economy and in the markets,” said Sheets, using the Fed chairman’s nickname. “But given that it is public, he needs to be careful. . If he is very optimistic about rate hikes, markets will take that as a significant green light for rates to rise. “
“The Fed is comfortable with an organic rate hike, reflecting changes in views on growth and inflation,” he added. “But I think the Fed also wants to be careful not to create and amplify a self-sustaining dynamic that pushes rates up for other reasons.”
These “other reasons” are mainly the fear of overheating the economy.
Stimulation and more stimulation
The Fed ran a historically loose policy last year, lowering its benchmark loan rate to almost zero and buying at least $ 120 billion in bonds each month. This adds up to a series of overdue loans and liquidity programs, implemented in the early days of the Covid-19 crisis.
Along with that, Congress has filed more than $ 3 trillion in fiscal stimulus and can approve up to $ 1.9 trillion more by the end of the week.
All of this happened in the midst of an economy that, in addition to a job problem that is still worrying mainly in the service sector, is buzzing. Wall Street is assuming growth expectations for the first quarter and market-based inflation indicators are rising.
That’s why Powell’s tightrope walk this week will be even more attractive.
“The market climate has changed,” said Mohamed El-Erian, chief economic advisor to Allianz, on Monday at CNBC’s “Squawk Box”. It is no longer if yields are rising, it is when the movement is very large. This is what the market is trying to find out. “
Investors are particularly concerned that all the stimulus is not going overboard and threatening to destabilize the economy in the long run.
“I can predict that the yellow lights are flashing across the Fed because of the [yields] movement and the slope of the interest curve, and the Fed can do more to try to control yields, “said El-Erian.
Fed officials have rejected so-called yield curve control to use their bond purchasing power to control rates between various fixed income maturities.
But the market may force the Fed’s hand, and Powell is likely to be asked what tools the Fed has to alleviate market problems. He repeatedly emphasized that the Fed has the weapons to control inflation, but deploying them comes with a price. Markets accustomed to low yields and companies accustomed to cheap borrowing costs could be shaken by an unexpected move by the Fed.
Evidence of how clearly the market is looking at the issue came Monday morning, when European Central Bank President Christine Lagarde said she was “closely monitoring the evolution of long-term nominal bond yields”. His words were enough to calm an agitated market and turn what had been an initial loss on Wall Street into a mixed market with the Dow up in the early afternoon. Treasury yields were virtually stable on the day.
Tom Lee, managing partner and head of research at Fundstrat Global Advisors, noted that “his clients have already expressed some apprehension about this week. Part of this reflects the fact that bond yields have been steadily rising and investors are concerned about the market. securities may reach some kind of ‘breaking point’ “during Powell’s testimony.
Powell speaks on Tuesday at the Senate Finance Committee while on Wednesday at the House Financial Services Committee.