Federal Reserve Chairman Jerome Powell testified during the Senate Committee on Banks, Housing and Urban Affairs hearing reviewing the CARES Act quarterly report to Congress on September 24, 2020 in Washington, DC.
Drew Angerer | AFP | Getty Images
Treasury yields soared on Thursday, as bond market participants grappled with the Federal Reserve’s willingness to allow inflation to heat up.
The 10-year Treasury yield soared from 1.64% on Wednesday night to 1.75% on Thursday, a 14-month high. It was 1.706% in the afternoon trading session.
The rise in yields – which move in opposition to the price – comes a day after Fed Chairman Jerome Powell assured the market that the central bank is not ready to cut its bond purchases and other support measures.
While bond market professionals say there was no development that triggered rising yields on Thursday, the market’s focus seems to have turned to the fact that the Fed plans to let inflation warm up.
“I think this is the bond market accepting the fact that inflation may be happening and may be occurring because the Fed is assuring us that they can live with inflation,” Sonal Desai, director of investments at Franklin Templeton Fixed Income Group , he told CNBC.
A steeper yield curve
The rise in interest rates, for the time being, does not represent a risk to the economy. The strategists say the yield is still relatively low, especially given the expectation of explosive economic growth this year.
However, the movement in overnight earnings was especially large, even considering the recent 10-year increase in income, which was at 1.07% six weeks ago. The 10-year benchmark is widely observed as it influences rates on mortgages and other loans to consumers and businesses.
The bond market barely moved on Wednesday afternoon, after the Fed issued its statement at 2 pm ET and after Powell informed the media.
Desai noted that the effect of the market reaction will be a steeper yield curve, which simply means a wider spread between earnings of different maturities, such as 2-year versus 10-year Treasury notes.
A steeper curve is often seen as a positive sign for growth, while a flattened curve can be a warning.
Ralph Axel, US rate strategist at Bank of America, said the market on Wednesday was responding to part of the Fed’s statement, which sent a mixed message.
“The first message that surprised people was that ‘we don’t believe in increases in 2023’,” he said. “I think that was where the initial focus was, and I think that kept the initial reaction dampened.”
The second message was that the Fed would keep rates low, let the economy warm up and increase inflation, to help recover lost jobs, Axel said.
Interpreting the Fed’s message about inflation
The market was responding directly to the Fed’s policy of allowing inflation to now occur in an average range around its 2% target.
“The market is struggling to find out what this [average inflation targeting] it means in practice, “said Axel.” We are beginning to understand that this means greater growth and higher inflation in the long run, which means higher interest rates. “
“When the Fed used to feel a breath of inflationary pressure, the Fed started to curb that,” he added. They would cut recoveries a little earlier. “
The idea was to avoid periods of highs and lows, while also cutting the potential for deeper recessions. However, the Fed is now facing an economy that can grow and, with very high economic growth, there may be inflation, said Axel of Bank of America.
Second quarter growth is expected to exceed 9%, according to CNBC / Moody’s Analytics Rapid Update.
Inflation remains low, with the core consumer price index excluding food and energy, registering an annual rate of 1.3% in February. However, as of this month, inflation levels may rise due to the base effect of last year’s big drop in prices during the economic downtime.
The market has challenged the Fed by fixing the price on rate hikes for 2023. Meanwhile, the central bank’s collective forecast, called dot plot, does not show consensus for a rate hike until 2023.
Managing treasury supply
Tony Crescenzi, portfolio manager and market strategist at Pimco, said the market is also assessing the fact that the Treasury will have to issue many supplies to pay the fiscal stimulus, given the most recent $ 1.9 trillion package and previous pandemic programs.
“A lot of what happened with the pricing of the Treasury’s offer and the ability of market participants to absorb that offer and this fear of inflation,” he said. “Part of this may be a scam, but no one knows for sure, so market participants need to assess the possibility that inflation may accelerate beyond what is expected.”
Market expectations are that inflation will be around 2.30% over the next 10 years.
“As long as general financial conditions remain conducive to the strengthening of economic activity, the Fed need not worry about raising interest rates so far,” said Crescenzi.
Choppiness in the stock market as yields increase
So far, the stock market has responded to the rate hike with agitated moves up and down. On Thursday, stocks fell after Wednesday’s hike, and the high-tech Nasdaq Composite was hit particularly hard.
“I would not be shocked if we had a bigger retraction in the stock market if that [10-year yield] goes to 2% quickly, “said James Paulsen, chief investment strategist at The Leuthold Group.
He said the stock market would be concerned if the pace of interest rate movement remains fast, but if it is able to adjust to increases gradually, that will not be a problem.
“If you’re going to have a year when rates are going to go up, it couldn’t be a better year,” said Paulsen, noting that economic growth could be 8%. “I think it is a very good year for this to happen with the economy and the stock market. Their vulnerability is not as great as it could be later on.”
Paulsen expects the 10-year yield to reach 2% by the end of the year.
Crescenzi said that since the 10-year yield level is partly based on inflation expectations, he had to adjust to the Fed’s use of the average target range, rather than a defined target.
“By indicating that it will delay the rate increase until inflation recovers and employment returns to the maximum level of employment, the anchor for inflation expectations is not so strong,” he said. to a certain extent.”
Crescenzi said the Fed’s dovishness on Wednesday could be a sign of a new view of the central bank.
“It seems to suggest that the Fed is taking a more holistic view of financial conditions, as Powell pointed out when he cited financial conditions as a whole, instead of focusing on yields alone,” he said.