- The Treasury market is challenging the Fed’s messages and signs of lasting economic damage.
- The rise in yields signals that investors expect the Fed to raise interest rates well ahead of previous estimates.
- Fed officials are likely to have to deal with the bond market crash to avoid interrupting the economic recovery.
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The Treasury market made it clear: the Federal Reserve is depressed.
Optimism about the US economic recovery blossomed last week. Daily COVID-19 case counts dropped further from January’s peak. Vaccination continued across the country, suggesting that the pandemic could disappear in just a few months. The economic data exceeded expectations. And Democrats have moved forward with President Joe Biden’s $ 1.9 trillion stimulus proposal, with the goal of further accelerating the recovery.
And yet, these encouraging developments have fueled a sudden shock to the Treasury market.
Investors looking to capitalize on a rapid recovery have discarded government bonds and directed money to riskier assets. The 10-year yield rose to 1.614% on Thursday, its highest level since the pandemic first hit the United States. The jump immediately attracted the stock’s appeal and pulled the main indices down over the week.
Markets Insider
The narrative behind the change is simple: increasing the likelihood of new stimuli driving recovery has raised expectations for faster economic growth and inflation. Stronger price growth leads investors to demand higher returns.
However, the market has reached such an extreme that it now contrasts with the forecast of the Federal Reserve itself. The central bank has indicated that it does not expect inflation to reach its target above 2% until after 2023. The outlook suggests that the Fed will keep interest rates close to zero until 2023.
The liquidation of Treasury bills, however, signals that investors are forecasting an increase in rates as early as the second half of 2022.
“Now we are getting to the point where the market is not necessarily believing what the Fed is saying,” Seema Shah, chief strategist at Principal Global Investors, told Insider. “Now we move to slightly more worrying terrain, where it seems that the Fed’s message is not powerful enough.”
Too much of a good thing
The central bank’s policy makers have remained steadfast until now. The jump in yields suggests that investors are expecting a “robust and ultimately complete recovery,” Fed Chairman Jerome Powell said on Tuesday. The president reiterated that the Fed will not reduce asset purchases or consider rate hikes until it sees “substantial progress” towards its inflation and employment targets.
In essence, liquidation is only part of the reflective trade, a strategy used to profit from stronger price growth. But the pace of rising earnings is a cause for concern, said Kathy Bostjancic, chief economist of the American financial market at Oxford Economics.
Thursday’s jump was the biggest single-day move since December, and overall bond market volatility has skyrocketed to its highest since April, according to Bloomberg data. Finally, the gains came despite the Fed continuing to buy at least $ 80 billion in Treasury bills each month.
Graph via BofA Research.
Bank of America Global Survey
As yields serve as a benchmark for the global credit market, a sudden increase can quickly raise borrowing costs, raising rates on mortgages, car loans and even utilities.
If yields gain very, very quickly, the price action could be “destabilizing,” said Bostjancic. The shock would come when real unemployment is still around 10% and the industries most affected by the pandemic are still far from fully recovering.
“It can stifle that fledgling recovery before it starts,” she said.
Others are not so concerned. Bank of America strategists led by Gonzalo Asis said the trend was less inspired by expectations of rate hikes and simply a case of “buying the fundamental drop” before strong economic growth.
There is room for yields to increase further, said Bostjancic. Real earnings – nominal earnings adjusted for inflation – remain negative, signaling that there is still enough weakness in the economy to justify putting the money in the safe haven.
Looking back to look ahead
This is certainly far from the first time that markets have reacted abruptly to tightening fears.
Concern over the premature tightening of monetary policy fueled the now famous “taper tantrum” of 2013, when investors quickly divested Treasury bills after the central bank announced it would slow its asset purchases, fueling a sudden shock. – although temporary – in the market title.
The Fed is likely to act first in this case to avoid further drama in the Treasury market, Bank of America economists led by Michelle Meyer said in a note on Friday. The updated economic forecasts to be published after the Federal Open Market Committee meeting in mid-March should offer some hints as to when the Fed’s rate hike criteria could be met, the team said.
“The risk, however, is that the Fed does not have the luxury of waiting for the next meeting and will have to respond to the market’s abrupt movements in speeches this week,” added the economists.
If the cholera crisis is anything at all, communication is a difficult balancing act for the central bank. Powell has said that he does not expect any stimulus-driven jump in inflation to be “big or persistent,” but that comment did little to calm the Treasury’s liquidation.
Unless the Fed further clarifies its inflation target, investors will not know when the reduction may occur, said Shah.
“There is a lot of room for interpretation in terms of how long inflation should be above 2%, at what level inflation should be above 2%,” she said. “This lack of clarity gives the market room to ask, ‘what does the Fed really mean by that?'”