Federal Reserve Chairman Jerome Powell testifies at the Senate Committee on Banking, Housing and City Affairs hearing examining the quarterly CARES Act report to Congress on September 24, 2020 in Washington, DC.
Drew Angerer | AFP | Getty Images
Treasury yields flared on Thursday as bond market players grappled with the Federal Reserve’s readiness to warm up inflation.
10-year Treasury yields shot up from 1.64% late Wednesday to 1.75% Thursday, a 14-month high. In afternoon trading it was 1.706%.
The rise in yields – which move in opposition to price – comes a day after Fed Chairman Jerome Powell reassured the market that the central bank is not ready to reverse its bond purchases and other supportive measures.
While bond market pros say there was no development that triggered the spike in interest rates on Thursday, the market’s focus appears to be on the Fed’s plan to warm up inflation.
“I think this is the bond market coming to terms with the fact that inflation can happen and it could be because the Fed assures us they can live with inflation,” Sonal Desai, chief investment officer at Franklin Templeton Fixed Income Group told CNBC.
A steeper yield curve
Rising interest rates do not pose a risk to the economy for the time being. According to strategists, the return is still relatively low, especially given the expectations for explosive economic growth this year.
However, the overnight yield was particularly strong, even given the recent 10-year yield increase, which was 1.07% six weeks ago. The 10-year benchmark is widely watched as it affects mortgage rates and other consumer and business loans.
The bond market barely moved on Wednesday afternoon, after the Fed issued its 2pm ET statement and after Powell briefed the media.
Desai noted that the effect of the market response will be a steeper yield curve, which simply means a wider spread between returns with different maturities, such as the 2-year Treasury bill versus the 10-year.
A steeper curve is often seen as a positive sign of growth, while a flattening curve can be a warning.
Ralph Axel, US interest rate strategist at Bank of America, said the market reacted Wednesday to part of the Fed’s statement, which broadcast a mixed message.
“The first message that surprised people was that ‘we don’t believe in 2023 walks,’” he said. “I think that was where the initial focus was, and I think that’s dampened the initial reaction.”
The second message was that the Fed would cut interest rates, warm the economy and increase inflation to help restore lost jobs, Axel said.
Interpret the Fed’s message about inflation
The market reacted immediately to the Fed’s policy of allowing inflation to hover around the 2% target on average.
“The market is struggling with what that does [average inflation targeting] means in practice, “said Axel.” We are starting to understand that in the longer term it means higher growth and higher inflation, which means higher interest rates. “
“If the Fed got a whiff of inflation, the Fed started to tighten up there,” he added. They would halt the recovery a little early. “
The idea was to avoid booms and busts by also cutting off the potential for deeper recessions. However, the Fed is now facing an economy that could thrive, and very high economic growth could come inflation, Bank of America’s Axel said.
According to the CNBC / Moody’s Analytics Rapid Update, growth in the second quarter is expected to exceed 9%.
Inflation is still low and the core consumer price index, excluding food and energy, was 1.3% year-on-year in February. As of this month, however, the inflation rate could rise due to the base effect of last year’s major price drop during the economic standstill.
The market has challenged the Fed by pricing in rate hikes for 2023. Meanwhile, the central bank’s collective prediction, the so-called dot plot, shows no consensus on an interest rate hike until 2023.
Treasury stock management
Tony Crescenzi, portfolio manager and market strategist at Pimco, said the market is also taking into account that the Treasury will have to spend a lot of money to pay for fiscal stimulus, given the most recent $ 1.9 trillion package and previous pandemic programs.
“Much of what has happened in the pricing of treasury stocks and the ability of market participants to absorb that supply, and these inflation fears,” he said. “Some of it could be a fake headline, but no one really knows, so market participants should consider the possibility that inflation could accelerate further than expected.”
Market expectations are that inflation will average around 2.30% over the next 10 years.
“As long as general financial conditions remain conducive to strengthening economic activity, the Fed should not be concerned about the rate hike so far,” Crescenzi said.
Stock market jerkiness when yields rise
So far, the stock market has responded to the rate hike with jerky up and down movements. On Thursday, stocks were lower after Wednesday’s rally, with the tech-heavy Nasdaq Composite in particular being hit hard.
“I wouldn’t be shocked if we had a bigger pullback in the stock market if this thing was [10-year yield] quickly goes to 2%, ”said James Paulsen, chief investment strategist at The Leuthold Group.
He said the stock market would be concerned if the rate of interest rate movement remains high, but if it can gradually adjust to the gains, it wouldn’t be a problem.
“If you’re going to have a year of rising interest rates, it couldn’t be a better year,” said Paulsen, noting that economic growth could be 8%. “I think it’s a pretty good year for the economy and the stock market. Their vulnerability isn’t nearly as great as they could be further down the road.”
Paulsen expects the 10-year yield to reach 2% by the end of the year.
Crescenzi said that since the 10-year return level is based in part on inflation expectations, it has had to adjust to the Fed’s use of the average target market, rather than a set target.
“By indicating that it will delay its rate hike until inflation picks up and employment returns to maximum employment, the anchor for inflation expectations is not that strong,” he said. to a certain extent.”
Crescenzi said the Fed’s moderation on Wednesday could be a sign of a new outlook from the central bank.
“It seems to indicate that the Fed has a more holistic view of financial conditions, as Powell noted by citing financial conditions as a whole, rather than going into returns itself,” he said.