Wall Street tests Jay Powell’s mettle as long-term bonds tumble

US financial conditions remain easy despite rise in long-term rates

“The market might push them to make a change in their behaviour but for now [Fed policymakers] have clearly indicated they do not want to directly participate in having an impact on the yield curve,” Rish Bhandari, a senior portfolio manager at hedge fund Capstone, said.

Mike Collins, senior portfolio manager at PGIM Fixed Income, warned that another sharp rise in Treasury yields could test their stance, however.

“Financial conditions do remain pretty loose, but if rates go up another [0.5 to 1 percentage point], that could really slow things down,” he said. The blowback in equity and credit markets could also be severe enough to prompt verbal intervention from the Fed, or even a shift towards the Fed buying more longer-term debt.

How the economic picture evolves as summer approaches could make the situation even thornier for the Fed.

Economists have already pencilled in a pick-up in consumer price increases this year as the economy reopens — a rise Fed officials say will be temporary. But the central bank’s endorsement of higher inflation, with its recent commitment to let inflation run hot to make up for past periods of undershooting its 2 per cent target, coupled with the enormity of the fiscal stimulus package recently signed into law have investors on edge.

Line chart of % showing Wall Street inflation expectations have bounced back strongly

“Markets have become incredibly concerned that the Fed will make a policy error in terms of higher inflation,” said Saira Malik, head of global equities at Nuveen. “The market can handle an increase in yields, but it needs to be orderly and driven by stronger growth and not going higher because the economy is overheating.”

Brian Rose, chief economist at UBS Global Wealth Management, said he was watching longer-term inflation expectations closely for any sign that inflationary pressures could become destabilising. Five-year break-even rates, which are derived from US inflation-protected government securities, now hover around 2.6 per cent, just shy of the highest level since 2008. The 10-year rate is slightly lower at 2.3 per cent. 

“If they are too successful and inflation expectations threaten to become de-anchored, then it becomes an issue and would make it a lot harder for the Fed to maintain very loose policy,” he said. On Wednesday, the so-called dot plot of policymakers’ interest rate projections implied that the central bank would keep interest rates close to zero until at least 2024, despite the sharp upgrade in its growth forecasts.

“There is nothing for now that tells us we are entering a new inflation regime that will . . . force the Fed to tighten,” said Diana Amoa, a fixed income portfolio manager at JPMorgan Asset Management. “That said, there is a lot more uncertainty around that.”


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