Wall Street tests Jay Powell’s courage as long-term bonds crumble

The US Federal Reserve is stuck in a high-stakes showdown with the markets.

This week, President Jay Powell won applause for recognizing a rapidly improving economic outlook and the possibility of a surge in inflation, while underscoring its commitment to keeping interest rates at their lowest levels for the foreseeable future.

But this relaxed attitude to inflation is pushing the price of long-term US government bonds up, spilling over into global markets. Despite Powell’s interventionist approach to rising yields, unlike his eurozone peers, investors continue to wonder how long the Fed can allow this to last.

“It’s not the level of return that matters, but how it interacts with risky assets,” said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. “If yields are rising at a rate that causes the stock market to fall and credit spreads to widen, then [Powell] will be much more concerned.

In the past week alone, the yield on the benchmark 10-year note climbed to 1.75%, after trading around 1.6% a few days earlier. Since the start of the year, long-term Treasuries, which mature in 10 years or more, have fallen nearly 15% on a total return basis, according to a Bloomberg Barclays Index. If those losses continue, the first quarter of this year will be the worst since at least the early 1970s.

The drop reflects a sharp update in inflation and growth forecasts among economists, and a suspicion that the Fed will eventually be forced to advance its first interest rate hike.

The European Central Bank has pushed back the rise in yields in its territory, fearing a harmful rise in borrowing costs for companies and individuals in a difficult economic context. In contrast, the Fed chairman swept aside any unease, despite the ferocity movement at times, in stark contrast to the March 2020 episode when policymakers constant contact with banks and other market participants on chaotic market movements.

The speed of the liquidation, which began to pervade the equity and credit markets, rattled investors. In February, yields beat even some of the highest expectations of the year, after an ill-received Treasury auction kicked off. choppy trading.

Powell again dismissed the recent market swings of $ 21 billion in US government debt on Wednesday, recalling that financial conditions across a variety of parameters remained “very accommodating” and that the central bank would only be concerned about “disorderly” movements that threaten to undermine economic recovery. To make this point clear, he suggested no intention of adjusting the Fed’s monthly $ 120 billion bond purchase schedule.

Financial conditions in the United States remain easy despite rising long-term rates

“The market could push them to change their behavior, but for now [Fed policymakers] made it clear that they did not want to participate directly in impacting the yield curve, ”said Rish Bhandari, senior portfolio manager at hedge fund Capstone.

Mike Collins, senior portfolio manager at PGIM Fixed Income, warned that another sharp rise in yields on Treasuries, however, could test their position.

“Financial conditions remain fairly loose, but if rates rise another [0.5 to 1 percentage point], that could really slow things down, ”he said. The pushback in equity and credit markets could also be severe enough to prompt verbal intervention by the Fed, or even a shift toward buying longer-term debt by the Fed.

The development of the economic situation as summer approaches could make the situation even more difficult for the Fed.

Economists have already looked at a pickup in consumer price hikes this year as the economy reopens – a ascend Fed officials say it will be temporary. But the central bank’s approval of higher inflation, with its recent pledge to let inflation heat up to offset past periods of under-exceeding its 2% target, coupled with the enormity Recovery plan recently signed into law have investors on the lookout.

Line chart of% showing Wall Street inflation expectations have rebounded sharply

“Markets have become extremely concerned that the Fed will make a policy error in terms of rising 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 rise because the economy is overheating.”

Brian Rose, chief economist at UBS Global Wealth Management, said he was watching long-term inflation expectations closely for any signs that inflationary pressures could become destabilizing. The five-year break-even rates, which are derived from inflation-protected U.S. government securities, are now hovering around 2.6 percent, just below the highest level since 2008. The 10-year rate is slightly less than 2.3 percent.

“If they are doing too well and inflation expectations threaten to uncheck, then that becomes a problem and would make it much more difficult for the Fed to maintain very loose policy,” he said. The so-called dot plot of policymakers’ interest rate projections on Wednesday implied that the central bank would keep interest rates close to zero until at least 2024, despite the sharp improvement in its growth forecast.

“There is currently nothing to indicate that we are entering a new inflation regime that will. . . force the Fed to tighten, ”said Diana Amoa, bond portfolio manager at JPMorgan Asset Management. “Having said that, there is a lot more uncertainty about this.”

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