One month ago, it cost the US Treasury 1.85% to borrow money for ten years. Now that cost is 2.69%, an 84bps difference. The increase for a two-year maturity has been even greater. The magnitude of this year’s rise in bond yields is profound no matter how you look at it. Even the sharp increase in 1994, an infamous year for the bond market, wasn’t quite as painful in as short a period of time. The good news is that for investment officers with money to spend, it’s a very welcome opportunity to put higher yields into the bond portfolio and boost earnings.
The first quarter chaos is largely due to the Fed’s scrambled attempt to get back in front of the market after failing woefully to acknowledge the sustainability of the current decades-high rates of inflation. Now they’re walking a tightrope and hoping to keep hold of the baby while ditching the bathwater. The minutes from the March FOMC meeting, as well as a parade of Fed officials, are reinforcing their commitment to aggressively tighter policy. Market sentiment as evidenced by the flat-to-inverted yield curve is flashing some early warning signs of recession at some point, but the timing is tricky. Futures markets at last check were calculating a 2.55% “implied” rate for Fed Funds by the end of the year, and the spread between 2yr and 10yr T-Note yields has ranged between -2bps and 20bps in recent sessions. A slight re-steepening of the curve that took place after release of the minutes can be viewed as quiet applause for the Fed’s newfound seriousness.
Among Fed speakers this week, James Bullard was again the alpha-hawk, bluntly stating that the Fed was behind in its mission to get an “exceptionally high” rate of inflation under control and suggesting that they’ll need to move “forthrightly” in order to get to the “right level” to deal with it. For him, that means a Fed Funds rate above 3%. Several policymakers favored a more aggressive interest rate hike in March (rather than the 25bps they did) to kick off a series of increases this year, but the FOMC held off due to uncertainty regarding the war in Ukraine. Fed Chair Powell said later that nothing would keep them from hiking rates by 50bps in coming meetings if that was deemed appropriate. Markets seem to be building-in that expectation.
Another key takeaway from the minutes is that they plan to begin balance sheet reduction or Quantitative Tightening (QT) as soon as the May meeting. That is welcome news to those of us concerned about market distortions and artificial asset price bubbles from a Fed balance sheet that now approaches $9 trillion. The QT process introduces potential complications for reserves targeting. They’ve created an asset/liability mismatch for themselves by buying assets further out on the maturity spectrum, funded by the creation of bank reserves. Reversing that won’t be easy. Stay tuned.
The data this week was relatively light: factory orders, durable goods, and manufacturing activity came in largely as expected. Next week promises to be more exciting as we’ll get data for inflation, retail sales, and consumer sentiment among other things. And next Friday will be a Good Friday indeed.
Federal Reserve Balance Sheet: 2005 – Today
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