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The US bond market will be aware of the U.S. Federal Reserve’s continued assurance that it will maintain its bond purchases for the foreseeable future – or risk a disorderly increase in yields.
Yields reached 10-month highs this month, after Democrats gained control of the U.S. Senate, raising the stakes on higher fiscal spending, rising inflation and possibly a faster economic recovery.
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Speculation also increased that the Fed would be quicker to withdraw its support for the U.S. economy, possibly even reducing bond purchases this year.
But the increase in yield, with 10-year yields jumping over 20 basis points in a week to 1.177%, prompted Fed officials to back down – and yields returned to 1.036%.
Fed President Jerome Powell said on January 14 that it is too early for the central bank to discuss changing its monthly bond purchases.
“Powell was in full swing with the message,” said Lou Brien, market strategist at DRW Trading in Chicago. “Powell doesn’t want the market or the public to make assumptions about ending the Fed’s accommodation; he wants to be the one who makes the incremental adjustments to the outlook. “
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When the economy improves substantially, “and we can see it clearly, we will notify the world, communicate very clearly to the public, and we will do it well before active consideration” of any policy changes, said Powell.
Its ability to prevent the market from leading potential Fed movements will be instrumental in determining whether future yield increases will become disruptive, analysts said.
If investors start pricing less support from the Fed before the economy shows improvement and the Fed indicates that it is ready, yield increases can hurt any recovery and hurt riskier assets, including stocks.
“It is critical in the context of the recovery you expect in 2021 that the Fed will remain very reliable in its dovish messages,” said Bruno Braizinha, interest rate strategist at Bank of America in New York.
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He expects yields to gradually increase, with an expectation of acceleration in the second half of the year. “But for this move to be ordered, it is necessary for the Fed to maintain a combined message about removing accommodation,” he said.
The biggest risk of a “tantrum”, which could be a 50 basis point increase in 10-year earnings over two months, will be near the end of the second quarter or the beginning of the third quarter, when the economy is expected to show improvement, said the Bank of America.
“Even if the Fed remains peaceful, it will be difficult to control the message at that point,” said Braizinha. If there is a sharp increase for the area of 1.5% to 1.75% without a solid economic improvement, this “will impact the prospect of risky assets”.
Another important component regarding the impact of higher yields will be whether they are driven by higher inflation expectations.
Yield increases caused by buying Fed bonds may hurt stocks, but “if yields go up because the economy is on fire and inflation expectations are going up, then it’s okay for stocks,” said Peter Berezin, strategist global head of BCA Research in Montreal.
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Real 10-year yields, Treasury yields that adjust to expected inflation, are trading at minus 1%, after this month’s inflation expectations jumped to 2.17%, the highest since May 2018.
A possible beneficiary of increased bond yields could also be bank shares, Berezin said. “They are not only cheap, but also a protection against a greater than expected increase in earnings.”
(Reporting by Karen Brettell; Editing by Megan Davies and Dan Grebler)