Recently we published a paper that argued that bond yields would rise significantly further, as much stronger economic growth with the reopening of the economy would be associated with a rise in real rates and inflationary expectations (US bond yields to rise significantly further, February 26, 2021). Yesterday, in a press conference, Federal Reserve Chair Jerome Powell, “disappointed markets” because he did not ease investor fears about rising bond yields by describing how the Fed would constrain them. Market participants should not have been disappointed. The disappointment stems from a misperception about the Fed’s ability to manage bond yields.

 

To repeat a paragraph from our paper, which we had emphasized in bold and italics:

“Such a recovery in bond yields as the economy recovers would be a natural adjustment. In fact, it would be unnatural if bond yields did not adjust. Too many market participants think the Fed can keep a lid on bond yields. The Fed administers short-term rates and can temporarily influence bond yields, but it is a misperception that the Fed can ‘manage’ bond yields on any sustained basis”.

 

The Fed is in a bind, on many dimensions. Regarding bond yields, the Fed would like bond yields to remain low, which would keep private sector borrowing rates low, like mortgage rates, but it knows that bond yields are well below their levels just prior to the pandemic, and it has limited ability to constrain bond yields. Ramping up the magnitude of its asset purchases (QE) in an environment of economic strength and concerns about inflation would add fuel to the flames and be unwise. The Fed understands that this could backfire and damage its credibility. Yield curve control (YCC) also makes no sense in the current environment of rising yields; it would signal open-ended QE.

 

The Fed could announce that it is extending the duration of its portfolio by buying more longer-duration bonds and allowing short-dated securities to mature while maintaining the current pace of asset purchases. This may temporarily constrain bond yields. The Fed knows that eventually it will have to begin tapering the magnitude of its asset purchases, and subsequently raise rates. The pricing in of such a policy shift by the futures markets is appropriate.

 

The realities are real bond yields remain below zero, inflation is becoming a concern, the economy is on the verge of reopening and significant strengthening, and there is an unprecedented amount of fiscal and monetary stimulus in the pipeline, and the Biden Administration is adding much much more.

 

Financial markets will have to set aside their normal craving of stimulus and deal with higher bond yields.

 

Mickey Levy, mickey.levy@berenberg-us.com

 

 



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