U.S. bond market tantrum: Here's what it would mean for the Fed

U.S. bond market tantrum: Here's what it would mean for the Fed

The bond market tantrum that drives up yields can be a fearsome prospect for central banks, but the U.S. Federal Reserve might just welcome a sell-off that lifts Treasury yields towards levels that better reflect the robust state of the economy.

Persistently low yields are a feature of bond markets in developed world, with global banks mostly in no hurry to raise interest rates and a global savings glut that keeps debt securities in constant demand.

But in the United States, the opposition between fiscal recovery and bond yields is strongest.

Even with growth forecasting to exceed 6% this year and a decrement in sight for the Fed's bond-buying programme at the end of this year, 10 year yields are still stuck at just above 1.3%. The Fed probably enjoyed low yields in the initial stages of the economic recovery, but now needs bonds to respond to the end of pandemic linked recession, said Padhraic Garvey, ING Bank’s head of research for the Americas.

Current pricing, analysts say, looks more consistent with the heightened economic uncertainty, whereas higher yields would align markets more with the signals coming from central banks.

We argue that there needs to be a tantrum to facilitate that. If the Fed had a taper announcement and there was no tantrum in fact that in fact is a problem for the Fed, said ING's Garvey.

Analysts say a bond market tantrum would involve yields rising 75 - 100 basis points bps within a few months.

The original taper tantrum in 2013 boosted U.S. yields just over 100 bps in the four months after that Fed boss Ben Bernanke hinted at an unwinding of stimulus measures in 2012.

But this kind of sudden Jump in yields seems unlikely right now, given how clearly the Fed announced its plans to taper its bond-buying. And as 2013 showed, bond market tantrums carry nasty side effects including equity sell-offs and higher borrowing costs worldwide.

A happy medium, analysts say, would be for benchmark yields to rise 30 - 40 bps to 1.6 - 1.8%.

In addition to wanting higher yields to better reflect the pace of economic growth, the Fed also needs to recoup some ammunition to counter future economic reversals.

The Fed funds rate - the overnight rate that guides U.S. borrowing costs - is in zero to 0.25% and U.S. policymakers are disinclined, unlike the Bank of Japan and the European Central Bank, to take interest rates negative.

The Fed won't want to find itself in the position of the ECB and BOJ, whose stimulus options at present are limited to raising rates further into negative territory or purchasing more bonds to underwrite government spending.

Jim Leaviss, chief investment officer at M&G Investments for public fixed income, said policymakers would probably like the Fed fund rate to be at 2%, so when we end up in the next downturn, the Fed will have some space to cut interest rates without hitting the lower bound of zero quickly. Another reason high yields could be welcomed is because banks would like steeper yield curves to boost the attractiveness of making short-term loans funded from depositors or markets.

Thomas Costerg, senior economist at Pictet Wealth Management, notes that the gap between the Fed funds rate and 10 - year yields is roughly 125 bps now well below the average 200 bps seen during previous peak economic expansion.

He believes the Fed would favour a 200 bps yield slope, not only because it would validate their view that the economic cycle is healthy but also because a slope of 200 bps is good for the banking sector's maturity transformation. But even a tantrum might not bring a lasting rise in yields.

The Fed should look with envy at Norway and New Zealand, where yields have risen in anticipation of rate hikes, it has stressed that its official rates won't rise for a while.

Structural factors are at play too, including the positive demand for the only AAA-rated bond market with large yields.

The Fed also guides rates in theory at least towards the steady rate of interest, the level where natural employment coincides with full inflation.

This rate shrunk steadily but still falls. Adjusted for natural inflation, the longer-run fund rate - the Fed's proxy for the projected inflation rate - has fallen to 0.5% from 2.4% in 2007. If correct, it leaves the Fed with little leeway.

Demographics and slower trend growth are cited as the reasons for the decline in the natural rate though a paper https: bit.ly 3 nVMxMv presented at the Jackson Hole symposium last month also blamed a rise in income inequality since the 1980s.

The paper said the rich, who are more likely to save, were taking a bigger slice of overall income and the resulting savings glut was weighing on natural rate of interest.

One lesson from this year is that there is a price-insensitive force, a massive gravitational force which is pressing down on Treasury yields, Pictet's Costerg said.