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US Fed faces tricky message

Jay Powell faces a tricky message this week

For the most part US Federal Reserve officials have come across as being quite relaxed about the recent move higher in yields at the long end of the US bond market.

At the beginning of the year the consensus wasn’t quite so cosy, with some members including Atlanta Fed president Raphael Bostic suggesting that the current pace of bond buying might be pared back if inflation started to edge higher, as new fiscal measures started to boost prices. It was these comments that helped fuel the initial rise in long-term US yields, as expectations of a faster recovery fuelled the prospect of a sooner than expected tightening of policy. This thought process was quickly stamped on by Fed chair Jay Powell and vice chairman Richard Clarida in the days afterwards, however the cat was out of the bag so to speak.

Since then, US 10-year yields have continued to rise, and while 2-year yields have remained well anchored in the mid-teens, markets don’t appear to be necessarily convinced that the Fed won’t be forced to act on the prospect of a strong economic rebound and a possible sharp rise in prices before 2024.

Fed chair Jay Powell has maintained that the recent rise in yields is a natural consequence of optimism over the prospects of a strong economic rebound in the wake of an economic reopening and another $1.9trn of fiscal stimulus, which has now been signed off, with the next set of payments set to hit US bank accounts in the coming days. This belief may be well founded, and makes perfect sense; however, the Fed’s relaxed attitude is likely to be tested further if yields continue their current upward march, with many predicting we could well see a move to 1.8% in the coming weeks on the US 10-year, while the move in the US 5-year yields has more than doubled to over 0.8%, from 0.36% at the end of last year.

The biggest concern the likes of Powell and Clarida may have at this week’s meeting, apart from stronger data, which seems inevitable at this point, is if more Fed officials shift their forecasts for the first-rate hikes into 2023, from 2024, given the strong growth outlook. Let’s face it, given the much more positive outlook, how can Fed officials not shift their forecasts in a positive way, unless they deliberately hold back in their dot plot estimates for how they see the economy performing? 

If they do shift their forecasts, which seems a plausible outcome, it's likely to make it much more difficult for Powell to manage the message tomorrow, if a significant number of Fed officials move their dot plot estimates from 2024 to 2023. Powell can insist as much as he likes that rates won’t move before 2024, but if the market thinks otherwise there won’t be that much he can do to change that shift in perception, which means in the longer term the risk won’t be in the long end, it will be in the short end.

We’ve already seen it in the 5-year yield with a sharp move higher in recent weeks. For now, the 2-year yield has remained well anchored, but a further run of decent data could well see this start to shift, especially if we move through the 0.2% level, which has been the top for most of the last 10 months. On this basis, surely a sell-off in the US 2-year treasury is only a matter of time.