The bond market is in rebellion over Biden’s stimulus – but not because it would be bad for the economy

• The Treasury market is defying messages from the Fed and signs of lasting economic damage.
• The surge in yields indicates that investors expect the Fed to raise interest rates well ahead of past estimates.
• Fed officials will likely have to grapple with the bond market rout to avoid disrupting the economic recovery.
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The Treasury market made it clear: the Federal Reserve is down.

Optimism about the US economic recovery has blossomed over the past week. The daily number of COVID-19 cases has declined from its peak in January. Vaccinations continued across the country, hinting that the pandemic could go away in just a few months. Economic data has exceeded expectations. And Democrats have moved forward with President Joe Biden’s $ 1.9 trillion stimulus proposal, aimed at accelerating the rebound even further.

And yet, these encouraging developments fueled a sudden shock in the Treasury market.

Investors looking to capitalize on a rapid recovery ditched government bonds and pushed liquidity into riskier assets. The 10-year yield climbed to 1.614% on Thursday, its highest level since the pandemic first hit the United States. The jump immediately reduced the appeal of stocks and pushed major indices down throughout the week.

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The story behind the move is simple: The increased likelihood that further stimulus will have contributed to the recovery has raised expectations of faster economic growth and inflation. Higher price growth leads investors to demand higher returns.

Yet the market has gone to such an extreme point that it now contrasts with the Federal Reserve’s own forecast. The central bank has indicated that it does not expect inflation to reach its target above 2% until 2023. The outlook suggests that the Fed will keep interest rates close to zero until 2023.

The sale of treasury bills, however, indicates that investors expect rates to rise as early as the second half of 2022.

“We’re now getting to the point where the market doesn’t necessarily believe what the Fed is saying,” Seema Shah, chief strategist at Principal Global Investors, told Insider. “We have now moved to slightly more worrying ground, where it seems the Fed’s message is not powerful enough.”

Too many good things

Central bank policymakers have so far held their own. The surge in yields suggests that investors expect a “robust and ultimately complete recovery,” Fed Chairman Jerome Powell said on Tuesday. The president reiterated that the Fed will not reduce its asset purchases or consider rate hikes until it sees “further substantial progress” towards its inflation and employment targets.

At its core, selling is only one part of reflation trading, a strategy used to profit from higher price growth. But the pace at which yields have risen is concerning, said Kathy Bostjancic, chief US financial markets economist at Oxford Economics.

Thursday’s jump was the biggest single-day move since December, and overall bond market volatility hit its highest level since April, Bloomberg data showed. Finally, the gains came despite the Fed continuing to buy at least $ 80 billion in Treasuries each month.

Since yields serve as the benchmark for the global credit market, a sudden surge can quickly increase borrowing costs, pushing up mortgage, auto loan and even utility rates.

If yields gain too much, too quickly, price action can be “destabilizing,” Bostjancic said. The shock would come as real unemployment is still around 10% and industries hardest hit by the pandemic are far from fully recovering.

“It could stifle this nascent recovery before it starts,” she said.

Others are not so worried. Bank of America strategists, led by Gonzalo Asis, said the trend was driven less by rate hike expectations and simply a case of “buying the fundamental down” before strong economic growth.

There is room for yields to increase further, Bostjancic said. Real returns – inflation-adjusted nominal returns – remain negative, indicating that there is still enough weakness in the economy to justify parking liquidity in the safe haven.

Look back to look forward

Admittedly, this is far from the first time the markets have reacted sharply to the tightening of fears.

Fears of a premature tightening of monetary policy fueled the now famous ‘taper tantrum’ of 2013, when investors quickly ditched Treasuries after the central bank announced it would reduce the pace of its purchases of ‘assets, fueling a sudden – albeit temporary – shock to the bond market.

The Fed will likely act first in this case to avoid further drama in the Treasury market, Bank of America economists led by Michelle Meyer said in a Friday memo. The updated economic forecast expected to be released after the Federal Open Market Committee’s mid-March meeting should offer clues as to when the criteria for a Fed rate hike may be met, the team said.

“The risk, however, is that the Fed will not have the luxury of waiting for the next meeting and will have to respond to sudden market movements in speeches this week,” the economists added.

If typing tantrum is anything to do, communication is a difficult balancing act for the central bank. Powell has previously said he didn’t expect a stimulus-fueled rise in inflation to be “significant or persistent,” but this comment did little to calm the sale of the bonds. of the Treasury.

Unless the Fed further clarifies its inflation target, investors will remain in the dark about when the cut might come, Shah said.

“There is so much room for interpretation in terms of how long inflation should be above 2%, at what level should inflation be above 2%,” she said. “This lack of clarity gives the market an opportunity to ask ‘what does the Fed really mean by this? “”