The US Federal Reserve is caught up in a high power struggle with markets.
President Jay Powell was praised this week for acknowledging a rapidly brightening economic outlook and the chance of an increase in inflation, while emphasizing his commitment to keeping interest rates at the lower level.
But this relaxed attitude toward inflation is keeping pace with the price of long-term U.S. government bonds, causing ripples across world markets. Despite Powell’s practical approach to rising yields, unlike its counterparts in the eurozone, investors remain wondering how long the Fed can keep it afloat.
“It’s not the level of return that matters, but how it interacts with risky assets,” said Gene Tannuzzo, head of fixed income at Columbia Threadneedle Investments. ‘If yields rise at a rate that leads to the stock market declining and credit spreads widening, then [Powell] will be much more concerned. ”
Just last week, the yield on the standard ten-year note rose as high as 1.75 percent, after trading just 1.6 percent just days earlier. Since the beginning of the year, long-term treasury, which matures in ten years or more, has fallen nearly 15 percent on a total return basis, according to a Bloomberg Barclays index. If these losses are sustained, the first quarter of this year will be the worst since at least the early 1970s.
The decline reflects a major upgrade among economists of inflation and growth forecasts, and a suspicion that the Fed will eventually be forced to raise its first rate hike.
The European Central Bank has moved back against the rise in yields on its grass, for fear of a detrimental rise in borrowing costs for businesses and individuals at a difficult economic time. In contrast, the Fed chair, despite the anger of the move at times, abolished any discomfort, in stark contrast to the March 2020 episode when policymakers were in constant contact with banks and other market participants about the chaotic market movements.
The rapid sell-off, which began to spread to stock and credit markets, knocked investors down. In February, yields even surpassed some of the highest forecasts for the year, after a poorly received Treasury auction started a bad trade.
Powell again on Wednesday rejected the recent $ 21 tonne breach in the US sovereign debt market, reiterating that financial conditions remain “very accommodating” in a range of measures and that the central bank will only be concerned about “disorderly” movements. which threatens to undermine. the economic recovery. To drive the point home, he suggested he did not want to adjust the Fed’s $ 120 billion monthly bond purchase program.
‘The market may encourage them to make a change in their behavior, but for now [Fed policymakers] has clearly indicated that they do not want to participate directly to have an impact on the yield curve, “said Rish Bhandari, a senior portfolio manager at hedge fund Capstone.
Mike Collins, senior portfolio manager at PGIM Fixed Income, warned that another sharp rise in treasury yields could test their position.
‘Financial conditions remain fairly loose, but if rates are even higher [0.5 to 1 percentage point], which can really slow things down, ”he said. The downturn in stock and credit markets could also be severe enough to bring about oral intervention by the Fed, or even a shift toward buying longer-term debt.
How the economic picture may develop as summer approaches could make the Fed even more difficult.
Economists have already shown an increase in consumer price increases this year as the economy reopens – an increase according to Fed officials will be temporary. But the central bank’s support for higher inflation, with its recent commitment to keep inflation warm to offset recent periods to lower its 2 per cent target, coupled with the size of the recently signed fiscal stimulus package , investors have on the point.
“Markets have become incredibly worried that the Fed will 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 has to be orderly and driven by stronger growth and not go higher because the economy is overheating.”
Brian Rose, chief economist at UBS Global Wealth Management, said he was keeping a close eye on long-term inflation expectations for any sign that inflationary pressures could become destabilizing. The five-year break-even rate, derived from U.S. inflation-protected government bonds, now hangs around 2.6 percent, just shy of the highest level since 2008. The ten-year rate is slightly lower at 2.3 percent.
“If they are too successful and inflation expectations threaten to become entrenched, it becomes a problem and will make it much harder for the Fed to maintain a very loose policy,” he said. On the so-called dot of the interest rate forecasts of policymakers, it was implied on Wednesday that the central bank would keep interest rates until at least 2024, despite the sharp improvement in its growth forecasts.
“For now, there is nothing to tell us that we will enter a new inflation regime that will go. . . forcing the Fed to tighten, ”said Diana Amoa, a fixed-income portfolio manager at JPMorgan Asset Management. “However, there is much more uncertainty about it.”