To let some hot air out of the markets? As long as it is not “cluttered”.
By Wolf Richter for WOLF STREET.
It seems rare to see a Treasury secretary and a Fed chairman coordinating his comments on rising long-term yields. On Friday, Treasury Secretary Janet Yellen, in an interview with PBS NewsHour, echoed what Fed Chairman Jerome Powell said on Thursday in an interview with the Wall Street Journal.
When Yellen was asked about the growing long-term earnings that crying babies on Wall Street are getting so nervous about, Yellen said in his quiet way: “Long-term interest rates have risen slightly, but mainly because market participants are seeing a stronger recovery, because we are successful in vaccinating people and a strong tax package that will get people back to work ”.
“Doesn’t raising interest rates worry you?” she was then questioned.
“I think they are a sign that the economy is getting back on track and market participants see this and expect a stronger economy,” said Yellen. “And instead of inflation staying below desirable levels for years on end, they are starting to see inflation return to a normal range of around 2%.” And inflation may rise more than that, but it will be transitory, she said.
Then, on Friday, the Treasury’s 10-year yield rose to 1.57%, still ridiculously low, given the prospects for inflation, and given the Fed’s insistence that it will let inflation exceed 2% – as measured by the “core PCE ”, inflation as it almost always produces the lowest inflation readings in the USA. But that 1.57% was, however, the highest since February 14, 2020:
The spread between 2-year Treasury yield (0.14%) and 10-year yield (1.57%) increased to 1.43 percentage points. By this measure, the yield curve is the steepest since November 2015:
This 10-year increase in income has sparked cries among Wall Street’s crying babies for the Fed to do something to bring them down. They have already outlined the solutions, including prominently another “Operation Twist”, in which the Fed sells short-term Treasury bills and buys long-term Treasury bills. This concentrated purchase of long-term Treasury bills would increase their prices and thus reduce their yields.
Crying babies on Wall Street are crying out for this because massive, highly leveraged bets on Treasury bills are producing massive losses.
Even conservative, worldly Treasury bond funds, focused on long maturities, are suffering increasing losses. From the lowest point in 10-year yield last August, the iShares 20 Plus Year Treasury Bond ETF share price [TLT] fell 19%.
And the 10-year yield is still at 1.57%. In November 2018, it was more than double and reached 3.24%. In April 2010, there was a day when the 10-year income exceeded 4%. Now those were the days! All we are talking about now is a meager 1.57%, and crying babies are in the mood to make the Fed cancel out those annoying yields that went wrong.
The Fed has responded in a unified voice to indicate that rising yields are a sign of strength and that, as long as it is a sign of increasing strength and not some tightening of financial conditions, it would let them rise.
It’s funny that Yellen has now pampered Powell and is singing the same hymn sheet with Powell to fight the crybaby on Wall Street.
His expression of comfort with higher long-term yields and rising inflation expectations came a day after Powell exposed the Fed’s position in an interview with the Wall Street Journal.
The Fed expects inflation to rise for two reasons, Powell said in the interview. The “base effect”, with the inflation rate falling in the spring of last year; and a “surge in spending” that can lead to “bottlenecks” with the reopening of the economy, which can create “some upward pressure on prices”. But the Fed will ignore “one-off effects” and any “transitory increase in inflation” and will be “patient” with rate hikes, he said.
To deal with rising bond yields, he said, “I would be concerned about the disorderly conditions in the markets or the persistent tightening of financial conditions that threaten the achievement of our goals.” The phrase “disorderly conditions” came up several times.
The speed of rising long-term earnings “was remarkable and caught my eye,” said Powell. “But again, it is a wide range of financial conditions that we are looking at, and that is really the key; there are many things. We want and would be concerned if we didn’t see “orderly conditions” in the markets, and we don’t want to see a persistent tightening in the broader financial conditions. This is really the test, ”he said.
So as long as conditions are not “disordered”, as long as the 10-year income zigzags in an “orderly” manner and does not overdo it, and as long as a “wide range of financial conditions” remains accommodative – they are still “highly accommodative,” he said – the Fed would let long-term yields do what they could and see them as a sign of economic strength and welcome higher inflation expectations.
On the other hand, if the markets again become disorganized, as in March, “the Committee is prepared to use the tools it has to promote the achievement of its objectives,” he said.
He declined to define at what level of 10-year yield the Fed would be nervous and start rummaging through its toolbox. But, apparently, that point is not yet close.
The effect is that higher long-term yields are leaving some of the hot air out of the markets. And the Fed may be encouraging this, as long as it is “orderly”.
The bond market has been under attack for months, with large losses spread over Treasury bonds with long maturities and investment-grade corporate bonds. The housing market will eventually respond to rising mortgage rates, and mortgage rates started to rise in early January.
But yields on high-risk bonds have barely risen from impressive low records. The demand for these instruments remains hot, amid record emissions so far this year. This enthusiasm for junk bonds – which allows all types of faltering companies to finance their cash burns – is a sign of “highly accommodating financial conditions”.
When BB’s average yield doubles to 7% and CCC’s average yield to 15% (my glue sheet for bond credit ratings), financial conditions are getting tighter, funding for cash-burning machines is getting harder and more expensive, and the Fed would be nervous. But that is not yet happening.
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