FILE PHOTO: The Federal Reserve Board building on Constitution Avenue is pictured in Washington, U.S., March 27, 2019. REUTERS/Brendan McDermid/File Photo
March 18, 2021
By Mike Dolan
LONDON (Reuters) – Far from fighting the Federal Reserve, bond markets have in many ways been remarkably well behaved and are acting right on cue. What’s not for the Fed to like?
Part of the market narrative of recent weeks has been that the Fed had somehow lost control of the U.S. Treasury bond market, allowing traders to become restive due to a lack of hard guidance, fear of excessive stimulus and inflation anxiety.
As borrowing rates backed up to pre-pandemic levels – already historically low levels before COVID-19 hit – and unsettled stock markets that have lapped up the idea of emergency borrowing rates for years to come, Fed officials refused to protest the move or offer the prospect of even more support.
Fed policymakers, who are concluding a two-day meeting on Wednesday, may well address technical money market disturbances from the rundown of Treasury’s bank account at the U.S. central bank – something flooding banks with excess reserves and raising questions about extending relief on their resulting purchases of more Treasury securities.
But even if this factor was the root of recent bond market ructions, the Fed’s fundamental message on its new average inflation targetting regime seems to be getting through just fine.
Not only are Fed officials expecting a temporary snapback in inflation to as high as 3% over the coming year, they are positively targetting 2%-plus so their average target is met by a symmetric period above that level matching the long periods stuck below it.
That’s the whole point of the strategy rethink – allowing the economy to run hot for periods to eat up accumulated slack and joblessness from periods of sluggish or sub-par growth.
And so while inflation fears grip the headlines, bond market pricing merely apes that objective rather than threatening it.
With oil prices more than double where they were at the nadir of the first pandemic-related lockdowns last year, forecast base effects on headline inflation will be sparky and unpredictable for several months – possibly even exaggerated later in the year by bottlenecks during the re-opening of shuttered services and travel.
But expectations embedded in inflation-protected bonds and in swaps markets show the five-year view similar to one-year indications of inflation around 2.50%.
While that’s a percentage point higher than 2019 levels and the highest since just before the banking crash of 2008, it’s in the ballpark of what the Fed’s been aiming at and shows just how long expectations skulked below target for the past decade.
Crucially, 10-year and 30-year equivalent expectations subside again to about 2.20/2.25%. And 10- and 30-year nominal bond yields of 1.6% and 2.4% are hardly excessive given they have room to move higher without cries about disjointed pricing.
It seems unlikely the Fed will be unnerved by a wobble in a stock market that is still near record highs and where worries about bubbles and one-way pricing were the bigger investor and policymaker fears only a month ago.
GRAPHIC: Tolerated Inflation Hump? – https://fingfx.thomsonreuters.com/gfx/mkt/xegpbgaedvq/tolerated.PNG
GRAPHIC: Cleveland Fed chart on inflation risks – https://fingfx.thomsonreuters.com/gfx/mkt/bdwvkmeyovm/Cleveland.PNG
FED IN CONTROL?
Where there is a challenge to Fed communication is market pricing for an interest rate hike at the tail end of next year – an aggressive take that flies in the face of the central bank’s signals that no move is likely on interest rates until 2023.
Were the Fed to push back hard on that, perhaps relatively benign inflation thinking may go up a notch too.
Beyond this week’s policy meeting, a wider worry is that what’s good for the Fed may not be for the rest of the world and the latter comes back to haunt Washington anyhow.
That’s partly a result of the still dominant role of the dollar and U.S. Treasury market in world finance – something Treasury Secretary and former Fed chief Janet Yellen has previously said influenced Fed thinking in the past.
Unicredit chief economist Erik Nielsen thinks that should throw down the gauntlet to global fiscal authorities to mirror the ambition of President Joe Biden’s massive $1.9 trillion spending package, which was enacted last week.
“For now, Biden and the Fed can sit back a bit and enjoy the spectacle of a much faster U.S. recovery, while the world of foreign governments, central banks and markets try to figure out how to react to this new and bold U.S. policy approach.”
But angst about loose policy settings and markets fighting the Fed remain largely a discussion of risk than a reality of pricing.
Bank of America’s latest fund manager survey showed more than 90% of respondents think “higher than expected inflation” is the biggest tail risk to investor positioning and a bond market “tantrum” the second.
Yet at the same time, they reckoned the 10-year Treasury bond would need to rise another 40 basis points to trigger even a 10% equity correction.
Deutsche Bank’s latest global outlook sees that yield move happening by the summer. But it reckoned a persistent overshoot of U.S. inflation in the 3% to 4% range would be needed to “elicit a strong response from the Fed” that would hit world markets hard.
As it stands – its central forecast is for U.S. inflation to end this year at 2.6% before subsiding to 2.1% by 2023.
And if that proves to be the case, the Fed can remain smug that it’s getting what it wants.
(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)
(Reporting by Mike Dolan; Editing by Paul Simao)