- Wall Street increasingly expects the Fed to intervene and cool the volatile Treasury market.
- Yields have increased in recent weeks, as investors have bet on growth that would exceed the Fed’s projections.
- If chaos continues without Fed action, rising yields could prematurely raise borrowing costs.
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Treasury market sales picked up the
Federal Reserve
attention of. What the central bank will do next is anyone’s guess.
The recent rise in Treasury yields, in fact, has followed a flood of good news. The Democrats’ huge stimulus bill, which promises to boost consumer spending, came closer to being approved. The daily COVID-19 case count continued to decline, and the average rate of vaccinations increased by more than 2 million doses per day. And the economic data pointed to the strength in the service and manufacturing companies.
These positive trends have led investors to prepare for stronger inflation and withdraw money from government bonds. The 10-year yield rose to 1.626% on Friday – its highest level in more than a year – after February’s payroll increase easily exceeded economists’ forecasts.
Fed Governor Lael Brainard – who played an important role in creating emergency lending programs during the pandemic – confirmed on Tuesday that the central bank is monitoring this chaotic jump in yields.
“Some of these changes last week, and the speed of them, caught my eye,” she said during a webinar with the Council on Foreign Relations. “I would be concerned if I saw disorderly conditions or persistent tightening of financial conditions that could slow progress towards our goal.”
Brainard’s comments suggest that the liquidation could force the central bank’s hand. If yields continue to rise at such a rapid pace, borrowing costs could skyrocket further and thwart the Fed’s efforts to keep rates low.
Wall Street expects the Fed to step in and pour some water into market volatility. Even so, Fed Chairman Jerome Powell did not take such a step.
The central bank chief said on Thursday that the Fed “will be patient” in waiting for inflation to approach its target above 2%. Inflation may skyrocket during the summer as the economy reopens, but it will take some time for price growth to stabilize above 2%, as the Fed wishes, Powell said.
The economy is also far from meeting the Fed’s employment target, he added before the February report was released.
“Yes, 4% would be a good unemployment rate, but it would take more than that to get the maximum job,” said Powell.
Still, he stopped reporting specifically on rising yields, only noting that “he would be concerned about the disorderly conditions of the markets or the persistent tightening”.
Wall Street sees next week’s Federal Open Market Committee (FOMC) meeting as a critical junction to find out whether the Fed is easing inflation fears or continuing to let the market run wild.
Governor of the Federal Reserve Board, Lael Brainard (L) and Powell (R).
Reuters
All eyes on the FOMC
Everything can change on March 17, when the FOMC is due to conclude its two-day meeting and update the Americans on its political position. Lawmakers are almost certain to keep rates at zero and to keep pace with asset purchases, but comments on recent movements in the treasury market and any changes in the Fed’s future direction will be closely monitored.
The March meeting will also end with the Fed’s publication of its latest economic forecasts. The latest estimates from Fed policymakers were released in December, before President Donald Trump approved a $ 900 billion stimulus deal and Democrats started promoting their $ 1.9 trillion aid plan.
The drop in daily COVID-19 cases since the December meeting could also prompt the Fed to offer more optimistic projections for growth, job creation and inflation. The updated forecasts may ease investor speculation about the Fed’s prospects and pacify the violent fluctuations in the Treasury market.
Regardless of how the Fed updates its messages, lawmakers will certainly act, Bank of America strategists led by Hans Mikkelsen said on Thursday. The rate market is expected to further test the Fed in the coming days to get a more forceful response from the authorities, they added.
“We expect spreads to widen and join the tightening of financial conditions, forcing the Fed to respond,” said the team.
Powell could provide further clarification on future policy measures as early as next week and “certainly not after the June meeting,” said Rick Rieder, director of global fixed income investments at BlackRock, on Friday.
“Sometimes change is difficult and sometimes policy needs to be prescribed for many; otherwise, uncertainty and volatility can rule the day,” he added.
Friday’s encouraging payroll report adds to the pressure the Fed is facing to control yields. Until the central bank can neutralize the most restrictive monetary conditions, each instance of positive economic news can fuel further market turmoil and exacerbate the rate problem, said Seema Shah, chief strategist at Principal Global Investors.
“With real yields reaching zero, the Fed is slowly running out of time to prove its determination and commitment to its average inflation target,” she added.
The tools in the Fed’s toolbox
The central bank has a considerable arsenal to increase its control over bond yields. Arguably, the safest and most likely option is for Powell to offer more detailed guidance on when to start tightening the policy. Clarifying the duration and the degree to which inflation is expected to stay above 2% would better prepare investors for future policy changes. Providing a stricter definition of “maximum employment” would have a similar effect.
If the central bank intervened more directly in the bond market, it could shift its bond purchases to longer-term bonds. This would put the focus on downward pressure on the Treasury bills most commonly used to assess borrowing costs.
The Fed could even fully increase its pace of asset purchases. The central bank already buys at least $ 80 billion in Treasury bonds and $ 40 billion in mortgage-backed securities each month. Raising values would likely pull yields down on all notes, but it could also raise new concerns about the size of the Fed’s balance sheet.
Probably the Fed’s most extreme option would be to design caps for bond yields with a policy known as controlling the yield curve. The move involves buying the Fed as many notes as necessary to prevent yields from rising above certain levels. However, this tool has not been put to use since World War II, and authorities have so far deviated from taking it seriously.
The central bank may still resort to any of its unused policies if conditions worsen, but taking such measures carries its own risks, said Patrick Harker, president of the Federal Reserve Bank of Philadelphia, on Wednesday.
“At this point, I am firmly committed to staying where we are. When you are in the middle of the crisis, the less things you can change the better,” said Harker, according to MarketWatch.