- Wall Street is increasingly expecting the Fed to step in to cool the volatile treasury market.
- Yields have risen over the past few weeks as investors bet that growth would exceed the Fed’s forecasts.
- If the chaos continues without Fed action, rising yields could increase borrowing costs prematurely.
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Treasury Market Sales Caught
Federal Reserve
‘s attention. What the central bank is doing next is anyone’s guess.
The recent rise in treasury yields has consequently followed a spate of good news. Democrats’ massive stimulus bill, which promises to increase consumer spending, has gotten closer. The daily COVID-19 number of cases continued to decline and the average rate of vaccinations rose above 2 million doses per day. And economic data showed strength in service and manufacturing enterprises.
These positive trends have led investors to get stronger inflation and cash out of government bonds. The ten-year yield climbed to 1,626% on Friday – its highest level in more than a year – after wage increases in February met the economist’s forecasts.
Fed Governor Lael Brainard – who played a key role in creating emergency lending programs during the pandemic – confirmed Tuesday that the central bank is monitoring this chaotic rate of return.
“Some of the moves last week and the speed of the moves struck me,” she said during a webinar with the Council on Foreign Relations. “I would be concerned if I see disorderly conditions or persistent tightening in financial conditions that could slow the progress towards our goal.”
Brainard’s remarks suggest the sale of the central bank could force a hand. If yields continue to rise at such a rapid pace, borrowing costs could rise higher and counteract the Fed’s efforts to keep rates low.
Wall Street generally expects the Fed to step in and throw water on market volatility. Yet Fed Chairman Jerome Powell has not taken such steps.
The head of the central bank said on Thursday that the Fed would be ‘patient’ to wait for inflation to trend towards its target of more than 2%. Inflation may skyrocket over the summer as the economy reopens, but it will take some time before price growth will gradually rise to more than 2% as the Fed wants, Powell said.
The economy is also far from achieving the Fed’s job goal, he added ahead of the February report’s release.
“Yes, 4% would be a good unemployment rate, but it would take more than that to get maximum employment,” Powell said.
He nevertheless continued to denounce the rising yields specifically, and only remarked that he would “be concerned about disorderly conditions in markets or persistent tightening.”
Wall Street sees the meeting of the Federal Open Market Committee (FOMC) next week as a critical juncture for whether the Fed dampens inflation fears or continues to drive the market.
Federal Reserve Governor Lael Brainard (L) and Powell (R).
Reuters
All eyes on FOMC
Everything could change on March 17, when the FOMC will close its two-day meeting and inform Americans of its policies. Policymakers are almost certainly keeping rates at zero and maintaining the pace of asset purchases, but comments on recent movements in the treasury market and any changes to the Fed’s forecast will be closely monitored.
The March meeting will also end with the Fed publishing its latest economic forecasts. The latest estimates from Fed policymakers were announced in December before President Donald Trump approved a $ 900 billion stimulus deal and Democrats began pushing their $ 1.9 billion emergency relief plan.
The decline in daily COVID-19 cases since the December meeting could also lead the Fed to offer more optimistic forecasts for growth, job creation and inflation. Updated forecasts could calm investors’ speculation about the Fed’s prospects and calm the wild swing of the treasury market.
No matter how the Fed updates its messages, policymakers will certainly act, Bank of America strategists led by Hans Mikkelsen said on Thursday. The rate market is ready to further test the Fed in the next few days to respond more forcefully to officials, they added.
“We expect the spreads to widen and join the tightening of financial conditions, which will eventually force the Fed to respond,” the team said.
Rick Rieder, chief investment officer of global fixed income at BlackRock, said Friday that Powell could provide further clarification on future policy changes as early as next week and “certainly no later than the June meeting.”
“Sometimes change is difficult and sometimes policy has 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 experiencing to curb yields. Until the central bank can counter the aggravated monetary conditions, every case of positive economic news could fuel new turmoil in the market and exacerbate the tariff problem, said Seema Shah, chief strategist at Principal Global Investors.
“With real yields gradually moving to zero, the Fed is slowly becoming timeless to prove its intent and commitment to its average inflation target,” she added.
The tools in the Fed’s toolbox
The central bank has a significant arsenal to sharpen its grip on bond yields. The safest and most likely option is probably that Powell will provide more detailed guidance on when it will start tightening the policy. To clarify the duration and extent to which inflation should rise above 2%, investors will be better prepared for future policy changes. A stricter definition of ‘maximum employment’ will have a similar effect.
If the central bank were to intervene more directly in the bond market, it could shift its bond purchases to longer dated notes. Doing so will focus the downward pressure on the Treasuries most commonly used to measure borrowing costs.
The Fed could even completely increase its rate of asset purchases. The central bank already buys $ 80 billion in Treasury and $ 40 billion in mortgage-backed securities every month. Increasing the amounts is likely to lower the yields of all notes, but could also raise new concerns about the size of the Fed’s balance sheet.
The Fed’s most extreme option would probably be to designate bond yield ceilings with a policy called the yield rate control. The move involves the Fed buying as many notes as needed to keep returns from rising above certain levels. The instrument has not been used since World War II, and officials have so far deviated from it to be seriously considered.
Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said Wednesday the central bank could still turn to any of its unused policies if conditions worsen.
“At this point, I’m determined to hold on to where we are. If you’re in the middle of a crisis, the less things you can change, the better,” Harker told MarketWatch.