Bond market signals room for Fed to raise rates without stalling economy
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The US government bond market is signalling that the Federal Reserve will be able to tame inflation in coming years without snuffing out growth in the world’s biggest economy.
Treasury yields jumped last week after a much stronger than expected US jobs report, as investors bet that strength in the labour market would give the Fed further impetus to tighten monetary policy as it sought to rein in the most intense consumer price growth in almost 40 years.
Despite the upbeat figures on the labour market, which pointed to rising wage pressure, expectations for future inflation barely budged. A Treasury market measure known as break-evens indicated that inflation would recede to less than 3 per cent in five years. That would mark a significant fall from the 7 per cent rate recorded in December. Longer term break-even rates suggest that markets are expecting the Fed to succeed in pushing inflation back towards its 2 per cent target.
The rising yields, coupled with steady inflation expectations, have pushed returns bond investors can expect to earn after inflation is taken into account sharply higher since the end of last year. Analysts say this increase in so-called real yields indicates traders are expecting the US economy to continue expanding in the years to come even as policymakers withdraw stimulus measures to slow intense price growth.
The yield on 30-year Treasury Inflation-Protected Securities (Tips) — a proxy for the real yield on the 30-year Treasury bond — broke above zero on Friday for the first time since June 2021. It closed last year at minus 0.47 per cent, according to Bloomberg data.
“The Fed’s control over the economy has just increased,” said Robert Tipp, head of global bonds at PGIM Fixed Income.
In 2021, the US economy rebounded from the historic pandemic-induced recession by growing at the fastest annual pace since 1984. Vaccines, a return to work and robust federal stimulus have all bolstered the rebound. But until recently, that had not been reflected in the Treasury market.
“Real rates were just absurdly low compared to economic fundamentals. So it only makes sense that they should be rising,” said Gregory Whiteley, portfolio manager at DoubleLine Capital.
Friday’s jobs report was just the latest in a series of indicators to illustrate this recovery.
The closely watched US payrolls report showed the economy added 467,000 jobs last month despite the recent rise in Covid-19 cases. It also included a substantial surprise upwards revision in jobs figures for November and December, and showed that wages had grown by more than expected.
The market responded by sending yields on US Treasuries jumping, with the 10-year yield hitting its highest level since January 2020.
The strong jobs report could have driven inflation forecasts higher: more jobs and higher wages give workers more money to spend, driving up demand for goods that are scarce because of problems in the supply chain.
Instead, traders have coalesced around the view that the Fed has more room to lift interest rates and cool the economy. As a result they ended the week by upping their estimates of how many times the Fed would tighten policy this year to more than five quarter-point rate rises, from between four and five a day before.
“Either the entire inflation market hasn’t gotten the memo or they have got the memo and the memo says inflation is going to come back to normal by the end of the year,” Chris McReynolds, head of US inflation trading at Barclays, said on Thursday.
Yields on longer dated break-evens are “very well contained. There’s no thought of sustained levels of inflation”, he added.
Real rates are still depressed by historical standards: the yields on five- and 10-year Tips notes remain below zero. Without further movement in real rates — or without a shift in inflation expectations — the yields on traditional Treasury bonds could stay low even as the Fed lifts interest rates.
Though the pace at which consumer prices are rising is expected to have hit a fresh 40-year high in January, there is some evidence that momentum may finally be starting to flag.
Economists polled by Bloomberg have forecast that core consumer inflation, which removes the effects of the volatile energy and food sectors, will rise in January at a slower pace than in December. Barclays economists cited moderation in the price pressures on clothing and on used cars for the expected shift.
“I’m a believer that the Fed missed the whole inflation thing, that they spent too long insisting it was transitory. But that was the 2021 scenario,” said Andy Brenner, head of international fixed income at NatAlliance Securities. “I do believe that inflation is going to subside.”