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'Keeping the punch bowl but not twisting the night away'

19 March 2021

Jeremy Sterngold, Head of Fixed Income

Broad equity markets and high yield bonds celebrated a strong cyclical recovery at the start of the year, supported by vaccine rollouts and additional monetary and fiscal policy. This resulted in the tech focussed Nasdaq 100 returning around 7% by mid-February before moving swiftly lower into negative territory, however it has since recovered from its lows. Despite the Federal Reserve (Fed) promising to supply the "punch bowl", in the form of continued bond purchases and keeping rates low, they have stopped short from further interventions despite sharp upward movements in bond yields. The speed of the move is remarkable considering ten-year US Treasury bond yields have risen from just over 0.9% at the start of the year, to around 1.7% following the meeting on Wednesday.

Inflation and real yields

We cannot look at conventional bond yields alone. In order to understand the moves better we need to look at inflation expectations and real yields (conventional yield less inflation expectations). Until mid-February, the rise in yields was solely driven by an increase in inflation expectations. Since then, the majority of the increase has been due to real yields. In essence, investors have moved to price a faster pace of rate hikes given increasing inflation concerns. Rising real yields have driven investors to reassess their growth equity weightings in light of the rising rate environment; this trend has been emulated across developed markets. The repricing in sovereign yields drove the European Central Bank (ECB) to announce last week, that they would increase the pace of their asset purchases. The ECB cited financial conditions as the trigger to ease policy further.

A change in predication

This week was the Fed and the Bank of England's turn to reinforce their view of “transitory” inflation pressures, but investors are not convinced. While both central banks continue to see a strong rebound in growth this year, well above levels we have seen for decades, they don’t see this as evidence of change in longer-term price pressures. They view the base effects of oil prices and temporary tax cuts as one-off factors that will push inflation higher later this year. In addition, stimulus cheques provide a one-off boost to consumption and may help the economy recover faster than without such fiscal policies. However, with both fiscal and monetary policies working on an unprecedented scale, investors fear the forces that may have been unleashed. The Fed remain committed to their purchases of $120 billion a month (split between $80 billion Treasuries and $40 billion mortgage backed securities) and stated they would give markets notice before tapering these purchases. The so-called “DOT” plot showed the majority of Fed members indicating that rates will remain unchanged until at least the end of 2023, although more members now see a chance for rate increases in 2023. The noteworthy change the Fed adopted this week was to emphasise that their forward guidance was “outcome-based”. This is a significant shift, as the Fed typically forecast the path of the economy and adjust monetary policy based on this. This new approach suggests they will wait for incoming economic and inflation data to see how recovery evolves relative to their expectations. Investors were not convinced by this approach; their concerns being if inflationary pressures prove to be more powerful than expected, the Fed will then be behind the curve resulting in a faster pace of rate hikes later on.

The Fed's approach

If the Fed responded more aggressively to the repricing that is causing tightening financial conditions, could this slow down the recovery? The answer probably lies with Chair Powell and other members of the Fed's previous experience with reducing accommodative policy stance. In 2013, bond markets underwent a “taper tantrum” after the Fed announced they would reduce the pace of their asset purchases resulting in ten-year Treasury yields moving quickly from 1.7% to 2.75%. Jay Powell, who was first nominated to the Fed in May 2012 prior to becoming Chair in 2018, is likely to be wary of intervening too abruptly in markets in order to avoid a repeat of the 2013 event. In addition, a revised inclusive employment mandate and allowing inflation to catch-up for previous periods of below target price pressures, allow the Fed more room to let the economy run “hot”.  

The Fed is in a difficult position; it could alleviate market pressure by redirecting all its purchases to the Treasury market, or readopt “Operation Twist” which shifts purchases from short dated Treasuries to longer maturity ones, this could force them to withdraw stimulus at a faster pace down the line. Ultimately, how bond market movements affect financing conditions is likely to be a trigger for further intervention. If companies are able to continue to access financing relatively easily, this is likely to keep the Fed reiterating that the current pricing reflects a better growth outlook, rather than seeking to manipulate the market following the enormous interventions last year.

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