With the taper set, the Fed is facing its hardest task yet

·Editor focused on markets and the economy

Thu, Nov 4, 2021, 2:53 AM3 min read

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Thursday, November 4, 2021

No taper tantrum in sight, rate hikes take center stage

On Wednesday, the Federal Reserve passed its first major test — announcing the slow normalization of policy without upsetting markets. In announcing that it would curtail bond purchases as growth slows and price pressures bubble over, markets responded by setting fresh records — which suggests the central bank walked the tightrope without falling off.

Wall Street economists applauded the Fed’s communication skills, which at a minimum didn’t ignite a “taper-tantrum” akin to 2013, when markets were roiled by the suggestion that monetary stimulus was being withdrawn.

Yet by all indications — i.e. surging inflation that central bankers insist is “transitory” (economists, of course, think otherwise) — the Fed’s hard work managing the market's expectations has only just begun.

While stocks cheered the Fed’s announcement, bond markets are telegraphing a slightly different story. After the Fed’s decision, shorter-term U.S. Treasury yields rose, with the 1-year yield hitting 0.170% — its highest since mid-June 2020, according to Tradeweb data.

1-Year US Treasury Yield: March 2, 2020 – November 3, 2021 (Tradeweb)

Shorter-dated government paper is traditionally the most sensitive to inflation and central bank expectations, and investors active in that particular part of the curve seem to think the Fed’s rate hikes will come faster than some expect.

Thus does Wall Street begin its newest parlor game: namely, when and by how much will rates inevitably rise.

While the central bank’s median forecast sees three to four hikes by 2023, a few Wall Street players are starting to suspect rising prices will eventually force the Fed’s hand. With the economy losing momentum, higher rates may cascade across a wide array of borrowing costs like bonds, credit cards and mortgages at the worst possible time.

According to Wall Street veteran Peter Boockvar, “the Fed now has three masters, the U.S. Treasury, the bond and stock markets and their officially anointed one, inflation and the jobs market. Thus, gradual will be their mantra in order to try to satisfy all as it always is when it comes time to tighten policy and they will unlikely deviate from what’s expected.”

Fed Chair Jerome Powell’s remarks “reiterate a desire for the Fed to remain patient as long as inflation allows but position itself to respond if price pressures surprise, especially in-light of current unique labor market dynamics,” Bank of America said in a research note on Wednesday.

“Overall, we remain comfortable with the view that the first rate hike will come at the end of next year, in 4Q,” the bank added. “However, should stronger persistent inflation materialize and consequently a reassessment of maximum employment, then the risks are for a pull forward.”

The direction of interest rates, US vs. the world (excluding China) (JPMorgan Chase)

The operative words here being “stronger” and “persistent inflation,” which is what a range of companies, executives and especially consumers are feeling, regardless of what bond yields are doing.

Franziska Palmas, a market economist at Capital Economics, thinks the rise in shorter-dated bond yields appears “overdone” and that longer-term rates will start to climb again.

However, there’s a growing lack of conviction among some economists about how tolerant the Fed can afford to be about building inflationary pressures, which show little, if any, signs of moderating.

“We suspect that delaying tightening against a backdrop of still relatively high inflation would build expectations for more hikes further down the line. We think this effect will be largest in the U.S., where we expect inflation to fall back less than many anticipate due to strong underlying inflationary pressure and the Fed’s willingness to tolerate above-target inflation.”

So let the game of chicken begin. But who’ll emerge victorious: Bond investors, or the Fed?

By Javier E. David, editor at Yahoo Finance. Follow him at @Teflongeek