The Federal Reserve’s policy was perfect during the worst of the coronavirus crisis, but the almost year-long streak appears to be. As Treasury long-term returns rise and financial markets raise expectations for rate hikes, Wall Street wants action. It did not get it today.
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Federal Reserve Chairman Jerome Powell said on Thursday that the increase in yields in bonds “caught my attention” last week, but said the policy remains very accommodating and does not indicate a new ‘turn’ in policy. The Nasdaq led renewed sales on Thursday afternoon as treasury yields jumped.
A Fed policy change could take place during the March 16-17 meeting. However, investors were looking for clues as to what the policymakers would do if Powell, Fed chief, participated in the Wall Street Journal Jobs Summit which began at 12 noon ET.
Powell said that “disorderly conditions in financial markets” or a sharp tightening of financial conditions could cause a policy change. But he goes on to say that recent market differences have met these tests.
The stakes are high: if the Fed succeeds in suppressing the upturn in the bond market, the stock market can start again.
In Thursday’s volatile stock market action, the S&P 500 climbed back into positive territory ahead of Powell’s speech, but fell sharply after speaking and tumbling below the 50-day line. The Nasdaq averaged its 50-day average on Wednesday, losing 2.7% and then dipping 2.2% on Powell’s comments. The Dow Jones, which did not fall much on Wednesday or Thursday morning, fell more than 1% and tested the 50-day line.
The ten-year treasury yield climbed by seven basis points to 1.54%.
Federal Reserve is no longer ‘in the right place’
Powell’s Fed chief has been saying for months that central banking policy is ‘in the right place’. Last week gave the first clear signal that is no longer the case. A $ 62 billion Treasury auction in 7-year government bonds on Thursday drew the worst demand in more than a decade. The ten-year treasury yield, which held below 1% before the Democrats won the Senate with a victory in two by-elections in Georgia on January 5, rose to 1.61%. This is the highest since February 2020.
In December, Fed projections for 2024 indicated no rate hikes. Still, “markets praised an increased interest rate hike by mid-next summer,” Wells Fargo economist Sarah House said Tuesday on the inflation outlook.
Whether the Fed policy is just fine or not, skeptical financial markets can tighten the policy, creating risk for stock prices and slowing the recovery. A further rise in treasury yields could also dampen enthusiasm for the Democrats’ vast infrastructure and tax package, which is expected to follow the $ 1.9 billion stimulus.
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Operation Twist Redux?
Wall Street is increasingly expecting the Fed to adopt a policy called Operation Twist, which was last used in 2011 and 2012. The Fed then sold $ 667 billion in short-term treasury proceeds and used the funds to buy long-term debt.
The Fed now holds more than $ 1 billion in treasury bills with a maturity of one year or less. A further $ 1.8 billion in treasury yields from one to five years.
A repeat of Operation Twist can help keep long-term returns that are key to mortgage rates and car loans. Doing so could also have a positive effect on the federal deficit, as Fed ownership will generate higher interest payments, which the central bank then returns to the treasury.
“Twist, a simultaneous sale of US treasuries and the purchase of longer dates, is the perfect prescription for the Fed,” Bank of America bank strategist Mark Cabana wrote this week.
Operation Twist Impact on S&P 500, Nasdaq, Treasures
If the Fed adopts Operation Twist, “the decline in stock prices will continue, led by the Nasdaq,” Ed Yardeni, chief investment strategist at Yardeni Research, wrote in a Tuesday note.
DataTrek Research co-founder Nicholas Colas finds that the experience of Operation Twist and its aftermath “shows that the Fed can absolutely suppress long-term interest rates by 100 (basis points) or more.”
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Plan B for the Federal Reserve: Point On SLR
If the Fed is not ready to turn around, there is another option on the table that could help establish the financial markets. At the end of March, the Fed will end relief for banks through a regulation known as the supplementary leverage ratio, or SLR.
Last year, in response to Covid, the Fed began excluding U.S. Treasury bank holdings and reserves parked with the Fed from calculations of how much capital buffers financial institutions should own.
Banks can respond to the reinstatement of the rule in a number of ways, but one would be to ease treasury holdings. This may contribute to upward pressure on yields, although the new stimulus increases the new treasury supply.
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