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Commentary: Is the Fed wary of sub-2 percent Treasury yields?
October 10, 2017 / 12:25 PM / 2 months ago

Commentary: Is the Fed wary of sub-2 percent Treasury yields?

LONDON (Reuters) - As the Bank of Japan explicitly targets zero percent 10-year government bond yields, a case could be made that U.S. Federal Reserve is more quietly nudging long-term Treasury yields up from 2 percent.

Federal Reserve Chairman Janet Yellen speaks during a news conference after a two-day Federal Open Markets Committee (FOMC) policy meeting in Washington, U.S., September 20, 2017. REUTERS/Joshua Roberts

It’s clearly not official policy and policymakers would be quick to dismiss any targeting outside of the Fed’s constitutional mandates. But timing of Fed guidance and market behaviour this year indicates a distinct reluctance at the central bank to seeing 10-year Treasury yields slip back below prevailing inflation rates.

The 10-year yield, the U.S. and global benchmark, has not dipped below 2 percent this year - although it came very close last month - and every time a slide towards or a break below that threshold has looked on the cards it has snapped back some 20 basis points or more.

Curiously, each one of those spikes has coincided with a welter of hawkish commentary in some form or other from Fed officials talking up the outlook for U.S. growth and inflation, or downplaying asset bubbles and financial instability risks.

 

It goes without saying that there has been no direct or even indirect Fed intervention in the bond market to steer the 10-year yield higher. But it’s safe to say Fed officials are more comfortable with it moving up, further away from 2 percent than falling back towards 2 percent.

“I don’t think they have an explicit target but they probably believe that 2 percent is very low given how tight the labor market is,” said Torsten Slok, managing director and chief international economist at Deutsche Bank in New York.

“Financial markets are overheating and gradually increasing long rates would be a good tool to try to slowly tighten financial conditions and thereby prolong the current economic expansion,” he said.

The Fed has raised rates a quarter of a percentage point four times since December 2015. Almost a decade on from the onslaught of the financial crisis, it will begin reducing its QE-inflated balance sheet later this year.

To say the Fed is proceeding cautiously is an understatement. Rate rises have been moderate in size and gradual in pace, and the balance sheet unwind is coming after a full three years of being kept steady at a record $4.2 trillion.

Yet the Fed is still tightening. Its vision of policy “normalization” won’t include a depressed or falling 10-year yield. Policymakers have downplayed the persistently flat yield curve, arguing that it doesn’t have the predictive powers of economic slowdown or recession it once had.

It’s in this light that the ebb and flow of the 10-year yield this year set against Fed commentary is illuminating.

GOTTA GET A MESSAGE TO YOU

On Jan 18, with the yield down more than 30 basis points over the preceding month at 2.31 percent, Fed chair Janet Yellen gave a speech to the Commonwealth Club of California in San Francisco.

“Waiting too long to begin moving toward the neutral rate could risk a nasty surprise down the road - either too much inflation, financial instability, or both,” she said.

Less than a week later, the 10-year yield was up at 2.55 percent.

The next month the yield was on the slide again, revisiting 2.31 percent on Feb. 24 before bouncing all the way up to 2.62 percent over the following three weeks.

No fewer than four Fed officials delivered upbeat comments on the U.S. economy between Feb. 20-22, suggesting that rates would soon go up again. They were duly raised on March 15.

On April 18, the 10-year yield was at its lowest point of the year around 2.17 percent. Between April 18-20 four Fed officials, including deputy governor Stanley Fischer, talked of the need to unwind the Fed’s balance sheet, the benefits of raising rates and the dangers of waiting too long to do so.

Barely two months later the yield was even lower, bottoming out at 2.10 percent on June 14. That very day the Fed raised rates, citing continued economic and labour market strength, and announced it would begin cutting its holdings of bonds and other securities this year.

In her news conference, Yellen struck an upbeat note on the economy, said the recent weakness in inflation was transitory and noted that the QE unwind could start “relatively soon”. The yield rose 30 basis points over the next month.

Most recently, on Sept. 8, the benchmark Treasury yield was 2.02 percent and the yield curve close to its flattest in a decade. A break below 2 percent seemed likely.

That same day New York Fed President William Dudley, one of the most influential Fed officials, said the yield curve wasn’t too flat and that inflation and wage growth were poised to rise. Lags in policy means the Fed should still act even with inflation below its 2 percent target, he added.

It may be coincidence, but the 10-year yield then rose nearly 40 basis points, hitting a five-month high of 2.40 percent last Friday.

Another rate hike this year is a nailed on certainty, if market pricing is to be believed, and the Fed will soon begin shrinking its balance sheet. The two-year yield is its highest in nine years, meaning the yield curve remains extremely flat.

This is not good for banks, who make money by borrowing at lower, short-dated rates and lending at higher, longer-term rates. Should the 10-year yield lurch lower again towards 2 percent, don’t be surprised if Fed officials start talking up the economy and rates again.

 The opinions expressed here are those of the author, a columnist for Reuters.

Reporting by Jamie McGeever Editing by Jeremy Gaunt

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