The US Federal Reserve is engaged in a high-risk confrontation with the markets.
This week, President Jay Powell received applause for recognizing a rapidly shining economic outlook and the chance for an increase in inflation, while emphasizing his commitment to keeping interest rates at minimum levels for the foreseeable future.
But this relaxed attitude towards inflation is affecting the price of long-term US government bonds, causing waves in global markets. Despite Powell’s indirect approach to raising yields, in contrast to peers in the eurozone, investors continue to question how long the Fed can allow this to work.
“It is not the level of income that matters, but how it interacts with risky assets,” said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. “If yields are rising at a pace that is causing the stock market to fall and credit spreads to widen, then [Powell] you will be much more concerned. “
Just last week, the yield on the 10-year benchmark jumped to 1.75 percent, having traded around 1.6 percent a few days earlier. Since the beginning of the year, long-term Treasury bonds, maturing in 10 years or more, have fallen by almost 15% based on total return, according to the Bloomberg Barclays index. If these losses are sustained, the first quarter of this year will mark the worst since at least the early 1970s.
The decline reflects a big rise among economists in inflation and growth forecasts, and a suspicion that the Fed will eventually be forced to anticipate its first increase in interest rates.
The European Central Bank retreated against rising yields in its territory, fearing a damaging increase in borrowing costs for companies and individuals in a delicate economic environment. In contrast, the Fed chair ruled out any discomfort, despite the ferocity of the movement at times, in sharp contrast to the March 2020 episode, when lawmakers were in constant contact with banks and other market participants about the chaotic movements of the market .
The speed of liquidation, which began to spread to the stock and credit markets, has shaken investors. In February, yields surpassed even some of the highest forecasts for the year, after a poorly received Treasury auction initiated heated negotiations.
Powell again rejected the recent swings in the $ 21 trillion market for US government debt on Wednesday, reiterating that financial conditions on a variety of metrics remained “highly accommodative” and that the central bank would be concerned only with movements “disorderly” that threaten to undermine the economic recovery. To clarify, he suggested no intention of adjusting the Fed’s $ 120 billion monthly bond-buying program.
“The market can pressure them to make a change in their behavior, but for now [Fed policymakers] they clearly indicated that they do not want to have a direct impact on the yield curve, ”said Rish Bhandari, senior portfolio manager at the Capstone hedge fund.
Mike Collins, senior portfolio manager at PGIM Fixed Income, warned that another sharp increase in Treasury yields could test his stance, however.
“Financial conditions are still very loose, but if rates go up more [0.5 to 1 percentage point], it could really slow things down, ”he said. The blowback in the stock and credit markets can also be severe enough to provoke verbal intervention by the Fed, or even a shift towards the Fed buying more long-term debt.
The evolution of the economic scenario with the approach of summer may make the situation even more thorny for the Fed.
Economists have already planned an acceleration in consumer price increases this year, with the economy reopening – an increase that Fed officials say will be temporary. But the central bank’s endorsement of higher inflation, with its recent commitment to let inflation warm up to make up for past periods of non-compliance with its 2 percent target, along with the enormity of the fiscal stimulus package recently signed into law it made investors nervous.
“The markets were extremely concerned that the Fed would make a policy mistake in terms of higher inflation,” said Saira Malik, head of global equities at Nuveen. “The market can handle an increase in yields, but it needs to be ordered and driven by stronger growth and not rise because the economy is overheating.”
Brian Rose, chief economist at UBS Global Wealth Management, said he was watching long-term inflation expectations closely for any signs that inflationary pressures could become destabilizing. The five-year breakeven rates, which are derived from inflation-protected United States government bonds, now hover around 2.6 percent, a little shy of the highest level since 2008. The ten-year rate is slightly less than 2.3 percent.
“If they are very successful and inflation expectations threaten to lose their anchor, it will become a problem and make it much more difficult for the Fed to maintain a very flexible policy,” he said. On Wednesday, the so-called dot plot of policymakers’ interest rate projections implied that the central bank would keep interest rates close to zero until at least 2024, despite the sharp rise in its growth forecasts.
“There is nothing for now that tells us that we are entering a new inflation regime that is going. . . force the Fed to tighten, ”said Diana Amoa, JPMorgan Asset Management’s fixed income portfolio manager. “That said, there is a lot more uncertainty around that.”