The Federal Reserve’s policy was perfect during the worst of the coronavirus crisis, but its streak of almost a year seems to be over. Now, as long-term Treasury yields rise and financial markets raise expectations for rate hikes, Wall Street wants action. I didn’t understand today.
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Federal Reserve Chairman Jerome Powell said on Thursday that last week’s rise in bond yields “caught my eye”, but said the policy remains highly accommodative and does not suggest a new “turnaround” in policy. Nasdaq led renewed sales on Thursday afternoon, while Treasury yields increased.
A change in Fed policy could happen at the March 16-17 meeting. However, investors looked for clues as to what policymakers will do when Fed chief Powell participated in a discussion at the Wall Street Journal Jobs Summit, which began at 12 noon Eastern time.
Powell said that “disorderly conditions in the financial markets” or a broadening of financial conditions would trigger a policy change. But he did not go so far as to say that recent market fluctuations meet these tests.
The stakes are high: if the Fed succeeds in suppressing the bond market uprising, the stock market recovery may begin again.
In Thursday’s volatile stock market action, the S&P 500 rose back into positive territory before Powell’s speech, but fell sharply after he spoke, falling below the 50-day line. The Nasdaq surpassed its 50-day average on Wednesday, losing 2.7%, and then plummeted 2.2% in Powell’s comments. The Dow Jones, which did not fall much on Wednesday or Thursday morning, fell more than 1%, testing its 50-day line.
The 10-year Treasury yield rose seven basis points to 1.54%.
The Federal Reserve is no longer “in the right place”
For months, Fed chief Powell said central bank policy was “in the right place”. Last week, it gave the first clear sign that this is no longer the case. A Treasury auction for $ 62 billion in 7-year government bonds on Thursday attracted the weakest demand in more than a decade. The 10-year Treasury’s yield, which had fallen below 1% before Democrats conquered the Senate with victories in two run-off elections in Georgia on January 5, rose to 1.61%. It is the largest since February 2020.
In December, the Fed’s projections did not indicate any rate hikes before 2024. However, “markets are pricing an increase in federal fund rates in the middle of next summer,” Wells Fargo economist Sarah House said in a statement. a conference on Tuesday on the outlook for inflation.
Whether the Fed’s policy is correct or not, skeptical financial markets can tighten the policy, creating risk for stock prices and delaying the recovery. A further increase in Treasury yields may also dampen enthusiasm about the Democrats’ large infrastructure and tax package, which is expected to follow the $ 1.9 trillion stimulus.
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Operation Twist Redux?
Wall Street increasingly expects the Fed to adopt a policy called Operation Twist, which was last used in 2011 and 2012. At that time, the Fed sold $ 667 billion in short-term Treasury yields and used these funds to buy long-term debt.
The Fed now holds more than $ 1 trillion in Treasury bills with a maturity of one year or less. Another $ 1.8 trillion in Treasury bills has yields of one to five years.
A repeat of Operation Twist can help maintain the long-term yields that are essential to mortgage and auto loan rates. This could also have a positive impact on the federal deficit, since the Fed’s holdings would generate higher interest payments, which the central bank would then pass on to the Treasury.
“Twist, a simultaneous sale of U.S. Treasury bills and the purchase of older bonds, is the perfect policy recipe for the Fed,” wrote Bank of America tax strategist Mark Cabana this week.
Operation Twist Impact On S&P 500, Nasdaq, Treasuries
If the Fed adopts Operation Twist, “the stock price crash will continue, led by Nasdaq,” wrote Ed Yardeni, chief investment strategist at Yardeni Research, in a note on Tuesday.
DataTrek Research co-founder Nicholas Colas found that the experience of Operation Twist and its aftermath “shows that the Fed can absolutely suppress long-term interest rates by 100 (basic points) or more.”
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Federal Reserve Plan B: Punt On SLR
If the Fed is not ready to root, there is another option on the table that can help liquidate the financial markets. In late March, the Fed is expected to end relief for banks from a regulation known as the supplementary leverage index, or SLR.
Last year, in response to Covid, the Fed began excluding banking assets from U.S. Treasury bills and reserves stationed at the Fed from calculations of how much of a capital buffer financial institutions should maintain.
Banks could respond to a reinstatement of this rule in a number of ways, but one would be to alleviate the Treasury’s holdings. This could contribute to the upward pressure on yields, even with the new stimulus increasing the Treasury supply.
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