Is the bond market doing the Fed's dirty work?
There is much ongoing debate about inflation and the Federal Reserve’s very transparent albeit implied path forward as far as reducing its monetary stimulus to ensure that inflation is indeed transitory rather than persistent.
The actions of the Federal Reserve – similar to the ECB – will likely be overtaken by market forces, starting with yields in the government bond market. Increases in yields will, in turn, have collateral effects into equities, but more on that in a moment. In the meantime, the only central bank that is likely to act quickly as far as increasing the bank overnight borrowing rate is the Bank of England. The yield on the 2-year Gilt started upwards in early September, well before one of the Bank of England governors suggested in early October that the central bank was sufficiently concerned about inflation (last read was Sept CPI at 3.1 %, here). Expectations are now that the BoE will act as early as November to lift the so-called Bank Rate – currently 0.10% – in order to quickly and effectively snub-out the threat of inflation. During the early September to early October period, the yield on the 2-year Gilt increased from around 0.20% to 0.50%, and the yield has increased another 24bps (to 0.74%) in just the last few days. The UK bond market is seeing the light, and the BoE will not hesitate to act quickly given its sole mandate to restore and then maintain inflation at 2.0%.
As far as the US, the Federal Reserve has articulated a more deliberate path towards normalisation, even though the last CPI reading for September was 5.4% (12-months rolling, here). The Fed has implied that it will likely decide at its Nov 2-3 FOMC meeting to begin tapering as soon as Nov/Dec which would carry on until it is fully wound down in mid-2022. Only when tapering is completed would the Federal Reserve consider raising the Fed Funds rate, since the US economy has yet to return to the full employment level existing just prior to the pandemic. As a reminder to readers, the Federal Reserve – unlike the BoE and ECB – effectively has a dual-mandate to maintain price stability (inflation at 2.0%) and achieve maximum full employment. It is the latter that seems to be dictating Fed policy at the moment, since the US unemployment rate of 4.8% (September reading) remains above the pre-pandemic level of 3.5% in February 2020, although down significantly from its peak in April 2020 of 14.8%. The Federal Reserve is convinced that current inflation is transitory. The jury remains out on this, although I believe that current high inflation is coming more from anomalies in supply as opposed to red-hot demand – see my article on cost-push inflation from October 8th here.
There is risk that the Fed acts too late as far as inflation though because its primary focus at the moment is on achieving full employment. The pickle that this presents for the Fed is twofold. Firstly, the bond market will react if the Federal Reserve does not, and it is already reacting accordingly. During the spike in longer-term US Treasury yields earlier this year, the yield on the 2-year UST remained anchored in the 0.15% to 0.20% range. However, as inflation continued to run hot throughout the summer and now into September, bond investors – some often referred to as “bond vigilantes” (1) – began to take matters into their own hands, initially pushing the 2-year yield to the 0.20%-0.25% range starting in mid-August. In mid-September, the yield on the 2-year UST began to move up faster, reaching 0.41% just last Friday (0.39% now at Oct 20th close). Similar to the UK Gilt market, the UST market is signalling that short term rates will need to be increased to quell inflation. However, at least until now, the Fed seems to be ignoring the message from UST investors, so much so in fact that in its last “dot plot” (extracted from “Summary of Economic Projections” from September 22nd), the consensus of the Fed governors seems to be that the Fed would not begin raising the Fed Funds rate until 2023.
The average difference between the 2-year UST yield and the Fed Funds rates has been 0.42% from January 1990 to October 2021 (standard deviation of 0.59%). That’s the historical context. From the start of the pandemic until mid-August 2021, the difference in Fed Funds and the 2y UST yield has been roughly 0.15%. The difference has now doubled in the last few weeks, increasing to 0.30%. I expect the short-end of the curve will continue to experience a sell-off as yields widen no matter what the Fed does, in the process effectively hijacking the Fed’s use of the overnight borrowing rate to influence monetary policy. That’s a bold statement, but I will go even go further by saying that should the Fed ignore the signals from the UST market, it will increasingly be held hostage – or at least influenced – by what happens in collateral asset markets. What I mean by this is that if the Fed’s policies continue to promote asset inflation and risk taking, the withdrawal of monetary stimulus will likely lead to the deflating of one or more asset bubbles which currently exist, potentially tipping the US economy into recession. This would likely cause the political pressure to be turned up to a very high temperature, further complicating matters. As I have stated in the past, I have serious doubts that the Fed can navigate the knife’s edge of delivering what would ideally be a soft landing as it normalises monetary policy, rather than keeping monetary policy too loose for too long, or tightening too quickly.
In summary, the Fed needs to better balance its dual mandates and pay more attention to signals from the US Treasury market. Tapering and Fed Fund rate increases do not need to be sequential events. The Federal Reserve should follow the cues from bond investors and act more quickly and decisively, not only to quell inflation (should it not be transitory) but also to increase the chance that a soft landing can be effectively navigated. Time is not on the side of a hesitant Federal Reserve, and it risks losing control if it doesn’t act quickly and decisively.
Note 1: Should you want to learn more about bond vigilantes and their thinking, I suggest you see this website: https://www.bondvigilantes.com/about