US Treasurys have taken a hit from the Fed’s hawkish tone, but investors are a lot less worried about inflation in the long run

Bull and Bear sculptures outside the Frankfurt Stock Exchange in Frankfurt,
Bull and Bear sculptures outside the Frankfurt Stock Exchange in Frankfurt,

  • The Federal Reserve has shifted its outlook for interest rates and inflation and short-dated bonds have taken a hit.
  • The Fed’s predictions have hurt global equities and lifted shorter-term Treasury note yields.
  • Longer-dated yields have fallen sharply, showing investors are not worried about a sustained pickup in inflation.
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The US Treasury market is showing investors are preparing for a faster pickup in inflation and borrowing rates, after the Federal Reserve indicated last week it could raise interest rates sooner than previously expected, but they don’t expect that to last.

When the Fed said after its monetary policy meeting that it could raise rates by the end of 2023 in response to more robust economic growth and inflation, global equities sold off, along with other interest-rate sensitive assets such as commodities, and short-term Treasurys in particular, sending 2-year yields to their highest in well over a year.

But that same hawkishness has not played out across the whole of the Treasury market. Since Wednesday last week, the yield on the 30-year US Treasury bond has dropped by around 20 basis points to its lowest since February, reflecting a belief among investors that the Fed will likely be successful in warding off a damaging inflationary spike.

It was last at 2.064% at 9.23 am E.T. on Monday.

In contrast, yield on the two-year Treasury note has risen by around 13.5 basis points since the Fed’s announcement, bringing yield up to 0.27% as of the early hours of US trading on Monday – its highest since January. This has brought the gap, or spread, between 2-year and 30-year yields to its narrowest since February.

St Louis regional Fed President James Bullard added fuel to the trade. He said in an interview on Friday the central bank could even raise rates by the end of next year. He also confirmed the Fed was discussing winding down its asset-purchase program.

The two-year Treasury note is the most sensitive to shifts in interest rate expectations and Bullard’s comments prompted the yield to almost double at one point in the day on Friday, before subsiding somewhat.

The steeper drop in yields on longer-term Treasurys, however, indicates investors believe the Fed will be likely be successful in tempering inflation and that they do not believe markets will experience a series of aggressive rate increases in the long-term. Instead they seem to expect a slowdown in economic growth, coupled with low levels of inflation in the long-term – even if inflation levels should rise sharply in the immediate future, analysts said.

Equities at least could be for more pain, at least in the short term, according to Jeffrey Halley, senior market analyst at OANDA. “If it continues, we may see an overdue reckoning for some of the dumber investment decisions being made by investors searching for yield in a zero per cent world-high yield credit and SPACs for a start.” he said.

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Don’t be fooled by the jobs report, the Federal Reserve isn’t hiking interest rates any time soon

fed chair jerome powell
Federal Reserve Chair Jerome Powell prepares to speak during a House Financial Services Committee hearing on Oversight of the Treasury Department’s and Federal Reserve’s Pandemic Response in the Rayburn House Office Building on December 2, 2020 in Washington, DC.

  • The jobs report was strong, but the US economy has a long way to go to bounce back from the COVID crisis.
  • This means the Federal Reserve isn’t going to ease up on its crisis measures anytime soon, and it certainly won’t raise interest rates.
  • Just listen to Fed Chairman Jerome Powell, he’s going to let the job market run hot. 
  • George Pearkes is the global macro strategist for Bespoke Investment Group.
  • This is an opinion column. The thoughts expressed are those of the author.
  • Visit the Business section of Insider for more stories.

Today’s jobs report from the Bureau of Labor Statistics was good news for the US economy, with businesses reporting 349,000 jobs added in February. But that good news, while welcome, is unlikely to mean anything for Federal Reserve policymakers, who have bigger plans for the labor market than a few strong jobs report numbers.

In a Q&A with the Wall Street Journal yesterday, Fed Chair Jerome Powell outlined the central bank’s areas of focus for the economy. In keeping with the changes to their long-term goals updated last year, the Fed’s labor market target is now “maximum employment”, which officials admit is “a broad-based and inclusive goal that is not directly measurable.” 

Instead of focusing on a single number like the unemployment rate or attempting to keep employment at a level that doesn’t create a risk of inflation, this approach admits that the relationship between inflation and labor markets has broken down in recent decades. So instead of obsessing over inflation and individual labor market numbers, the Fed now hopes to create conditions where jobs are plentiful for all who want them.

Recent experience suggests this is the correct approach. In the pre-COVID economic peak, 80.5% of Americans in their prime working years (25 to 54) had jobs, the highest since 2001 but well short of the record 81.9% from April of 2000. Despite that very broad labor market success, core inflation only rose 1.6% in 2019, illustrating that running labor markets hot was not causing inflation to soar.

This experience – a strong labor market with little inflation – should influence the Fed’s thinking going forward, especially when it comes to the emergency measures put in place to deal with the COVID crisis.

As the economy continues  to recover from COVID, markets have begun to assume that the Fed is going to start to roll back some of these crisis measures over the next year or so. Some investors and Fed watchers believe quantitative easing (purchases of Treasury debt and mortgage-backed securities guaranteed by the federal government) may be “tapered” this year or early in 2022. Interest rate hikes are also, in the view of these market participants, likely to follow. Markets point to investors assuming rates will not be raised this year but some pricing of potential hikes is creeping into the 2022 calendar year and multiple interest rate hikes are fully priced in 2023.

This speculation – both about QE easing and the potential for rate hikes in the next couple of years – is inconsistent with the guidance the Federal Reserve has offered. 

In yesterday’s Q&A, Powell said it was “highly unlikely” that maximum employment would be achieved this year, even though there is “good reason to expect job creation to pick up.” To illustrate why strong jobs growth doesn’t mean the Fed needs to tighten, the chart below shows the prime-age employment/population ratio. As it stands, in order to achieve the same level of employment as pre-pandemic, prime age workers economy would need another 5.04 million jobs.

pasted image 0 (9)

Maximum employment likely means a prime-age employment-population ratio well above the prior cycle highs, so the shortfall is even more than that 5.04 million jobs. For context, the solid February jobs report would need to be repeated every month for 14 months to get this ratio at or above its old peak, assuming every new job went just to this category. At the 154,000 pace of job creation for 25-54 year olds only, maximum employment is 33 months away.

This is just one example of how long the hole US labor markets are in will take to climb out of, but interest rate markets are pricing almost four 25 basis point hikes by the Federal Reserve by the end of 2023…which is 33 months away.

Only one thing can be true: either the interest rate markets are wrong, or the Fed is wrong in its commitment to returning the US to maximum employment. If you take the FOMC at its word, job creation numbers this year are almost irrelevant, even if they follow the solid pace set by February’s numbers. What’s really important is the distance to maximum employment, and that remains huge, leaving interest rate speculators only one out if they’re to be proven correct about the path of Federal Reserve policy.

Read the original article on Business Insider