US Treasury market already set the narrative ahead

The $21 trillion US Treasury market already set the narrative ahead of the Federal Reserve’s 17 March decision. Benchmark 10-year yields stormed to the highest level since January 2020, while 30-year yields reached 2.44% for the first time since August 2019. Bond traders were throwing yet another tantrum, as if to dare Fed Chair Jerome Powell to stop them. Instead, the Fed stayed true to its new framework. Yes, US economic growth will likely be robust this year, and inflation will probably average 2% over the coming years. But sans proof, it’s not going to be in any hurry to pencil in interest-rate increases.

As expected, the Federal Open Market Committee left the Fed funds rate unchanged in a range of 0% to 0.25% and didn’t fiddle with its asset purchases. Fed officials for the first time since December updated their economic projections, which showed expectations for economic growth of 6.5% this year and core inflation of 2.2% in 2021, 2% in 2022 and 2.1% in 2023. The US unemployment rate will probably fall to 4.5% this year, then 3.9% in 2022 and 3.5% in 2023, which would match the generational low set in late 2019 and early 2020.

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Still, that wasn’t enough to move the median forecast among Fed officials on the ‘dot plot’, which still shows an expectation that the US central bank’s benchmark rate will stay near zero through 2023. That’s not to say some policymakers weren’t swayed by two rounds of fiscal aid and widespread vaccinations: Seven of them predict raising rates in 2023, up from five in December, while four of them see rate increases beginning in 2022, rather than just one.

To be clear, if central bankers’ economic forecasts come to pass, the dots are bound to move higher. “The strong bulk of the committee is not showing a rate increase during the forecast period," Powell said. “Part of that is wanting to see actual data rather than just a forecast at this point. We do expect that we’ll begin to make faster progress on both labour markets and inflation as the year goes on because of progress with the vaccines, because of the fiscal support that we’re getting. We expect that to happen, but we’ll have to see it first."

Bond traders aren’t quite as patient. The reason Treasury yields have increased so much is that investors are starting to worry about a pickup in inflation. Bond-fund manager Bill Gross said on Tuesday that he’s betting against long-term Treasuries and sees inflation reaching 3% or 4% in the coming months. Greg Jensen, co-chief investment officer of Bridgewater Associates, said this week that “the pricing-in of inflation in markets is actually the beginning of a major secular change, not an overreaction to what’s going on." What bond traders don’t seem to quite understand is that this is exactly what the Fed wants to see. When Powell announced the central bank’s new average inflation targeting framework last August, he bemoaned how difficult it is to raise the nation’s collective expectations for future price growth after years of falling short of 2%.

Now comes the trickier part: Actually observing inflation above 2% for a sustained period of time. Fed Vice Chair Richard Clarida has suggested inflation would have to average 2% for a full year before raising interest rates, a hurdle which has almost never been met since the 2008 financial crisis. Fed officials have made clear that they expect to see outsized figures in the coming months and that those won’t cause them to change course. “I would note that a transitory rise in inflation above 2%, as seems likely to occur this year, would not meet this standard," Powell said.

Powell was pressed on what was missing from the Fed’s projections to hold off on forecasting an interest-rate increase in 2023. After all, core inflation in each year through 2023 is expected to be at least 2%. “The state of the economy in two or three years is highly uncertain, and I wouldn’t want to focus on the exact timing of a rate increase that far into the future," he said. “The fundamental change in our framework is that we’re not going to act pre-emptively based on forecasts, for the most part, and we’re going to wait to see actual data. I think it will take people time to adjust to that, and the only way we can really build the credibility of that is by doing that."

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Treasuries seemed to be grappling with this reality after the decision, with 10-year yield yields fluctuating between 1.68% and 1.62%. In an effort to alleviate pressure on short-term rates, the central bank did boost the daily counter-party limit in reverse repo operations, the first such increase since 2014. But it didn’t increase its interest rate on excess reserves. Bond traders may yet push longer-term Treasury yields higher in the coming days. But at least the initial market reaction suggests investors are coming to terms with the fact that the Fed isn’t going to be rushed into anything by a few loud tantrums.