The bond market is in revolt over Biden’s stimulus – but not because it would be bad for the economy

• The treasury market defies Fed messages and signs of lasting economic damage.
• Rising returns suggest that investors expect the Fed to raise interest rates before they are previously estimated.
• Fed officials are likely to have to deal with the mortgage market to prevent disruption of the economic recovery.
• Visit the Insider Business Department for more stories.

The treasury market has made it clear: the Federal Reserve is a declining factor.

Optimism for the US economic recovery has flourished over the past week. Daily COVID-19 numbers dropped further from their January high. Vaccinations have continued across the country, suggesting the pandemic could fade within months. Economic data beats expectations. And the Democrats continued with President Joe Biden’s proposal of $ 1.9 billion stimulus, which was aimed at accelerating the rebound even further.

And yet these encouraging developments have fueled a sudden shock in the treasury market.

Investors wanting to capitalize on a quick recovery have dumped government bonds and pushed cash into riskier assets. The ten-year yield rose to 1,614% on Thursday, the highest level since the pandemic first hit the US. The jump immediately cut in stock attractiveness and dragged the major indices lower throughout the week.

Market Insider

The story behind the move is simple: the increased likelihood that new stimulus will accelerate recovery has raised expectations for faster economic growth and inflation. Stronger price growth is leading investors to demand higher returns.

However, the market has moved to such an extreme that it now contrasts with the forecast of the Federal Reserve. The central bank has indicated that it does not expect inflation to reach its target above 2% until after 2023. The outlook indicates that the Fed will keep interest rates close to zero until 2023.

However, the sale in Treasurys indicates that investors will already be price-raising in the second half of 2022.

“We’re now at the point where the market does not necessarily believe what the Fed is telling,” Seema Shah, chief strategist at Principal Global Investors, told Insider. “We have now moved to a slightly more worrying ground, where the Fed messages do not seem to be strong enough.”

Too much of a good thing

Central bank policymakers have kept their man so far. The rise in yields indicates that investors expect a “robust and ultimately complete recovery,” Fed Chairman Jerome Powell said Tuesday. The chairman reiterated that the Fed would not reduce asset purchases or consider rate hikes before seeing significant further progress towards its inflation and employment targets.

The bottom line is that the sell-out is merely part of the reflection trade, a strategy used to take advantage of stronger price growth. But the rate at which yields have risen is worrying, said Kathy Bostjancic, chief financial officer of Oxford Economics.

Thursday’s jump was the biggest one – day move since December, and overall volatility in the bond market has risen to its highest level since April, according to Bloomberg data. Finally, profits came despite the Fed buying at least $ 80 billion a month in Treasurys.

As yields serve as a benchmark for the global credit market, a sudden rise in borrowing costs could quickly increase, causing mortgage rates, car loans and even utilities to rise.

If yields rise too fast too much, the price action could be ‘destabilizing’, Bostjancic said. The shock would come because real unemployment is still at around 10% and the industries that have been hit hardest by the pandemic are far from fully recovered.

“It could choke this budding recovery before it gets underway,” she said.

Others are not so worried. The Bank of America’s strategies led by Gonzalo Asis said the trend was less inspired by rate hikes and merely a case of ‘buying the fundamental decline’ before strong economic growth.

There is room for returns to climb even higher, Bostjancic said. Real returns – nominal yields adjusted for inflation – remain negative, indicating that there is still enough weakness in the economy to park cash in the safe haven.

Looking back to look forward

To be sure, this is by no means the first time that markets have suddenly responded to fear.

Concerns about the premature tightening of monetary policy fueled the now-famous ‘taper tantrum’ of 2013, when investors dumped Treasurys quickly after the central bank announced it would cut the rate of its asset purchases, prompting a sudden – although temporary – shock for the effect evoked. market.

The Fed is likely to move first in this case to avoid additional drama in the treasury market, Bank of America economists led by Michelle Meyer said in a Friday note. Updated economic forecasts to be published after the meeting of the Federal Open Market Committee should give some hints on when the Fed’s rate hike criteria can be met, the team said.

“However, the risk is that the Fed will not have the luxury of waiting for the next meeting and will have to respond to the sudden market movements this week in speeches,” the economists added.

If there is a tapered tantrum, communication is a difficult balance for the central bank. Powell has already said he does not expect any inflationary stimulus to be ‘large or persistent’, but comments have done little to sell out in Treasurys.

Unless the Fed further clarifies its inflation target, investors will remain in the dark when the downturn may come, Shah said.

“There is so much room for interpretation in terms of how long inflation should be above 2%, at what level inflation should be above 2%,” she said. “The lack of clarity gives the market room to wonder, ‘what does the Fed really mean by that?’