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Bond market watching for ongoing Fed reassurance on purchases

  • Another key component regarding the impact of higher yields will be whether they are driven by higher inflation expectations.
27 Jan 2021

The US bond market will be watching for ongoing reassurance from the US Federal Reserve that it will maintain its bond purchases for the foreseeable future - or risk a disorderly rise in yields.

Yields spiked to 10-month highs this month after Democrats won control of the US Senate, increasing bets on higher fiscal spending, rising inflation and possibly a faster economic recovery.

Speculation also grew that the Fed would be quicker to pull back its support of the US economy, possibly even tapering bond purchases this year.

But the yield increase, with 10-year yields jumping more than 20 basis points in a week to 1.187%, prompted Fed officials to push back - and yields have retraced to 1.036%.

Fed Chair Jerome Powell said on Jan. 14 it is too early for the central bank to discuss changing its monthly bond purchases.

"Powell was full throttle on the message," said Lou Brien, a market strategist at DRW Trading in Chicago. "Powell does not want the market or the public to make presumptions about the end of Fed accommodation; he wants to be the one who makes the incremental adjustments to the outlook."

When the economy improves substantially, "and we can see that clearly, we will let the world know, communicating very clearly to the public, and do so well in advance of active consideration" of any policy changes, Powell said.

His ability to stop the market from front-running potential Fed moves will be key for whether future yield increases become disruptive, analysts said.

If investors begin pricing for less Fed support before the economy shows improvement and the Fed indicates it is ready, yield increases could dent any recovery and hurt riskier assets, including stocks.

"It's critical in the context of the recovery that you expect in 2021 for the Fed to stay very credible in their dovish messaging," said Bruno Braizinha, an interest rate strategist at Bank of America in New York.

He expects yields to increase gradually, with momentum expected to pick up in the second half of the year. "But for this movement to be orderly, it's necessary that the Fed keeps a concerted message around the removal of accommodation," he said.

The biggest risk of a "tantrum," which could be a 50-basis point increase in 10-year yields in two months, will be near the end of the second quarter or beginning of the third quarter, when the economy is expected to show improvement, Bank of America said.

"Even if the Fed stays dovish it's going to be difficult to control the message at that point," said Braizinha. If there is a sharp increase to the 1.5% to 1.75% area without solid economic improvement, that "is going to impact the risky asset outlook."

Another key component regarding the impact of higher yields will be whether they are driven by higher inflation expectations.

Yield increases prompted by the Fed paring bond purchases could hurt stocks, but "if yields go up because the economy is on fire and inflation expectations are moving up, then that's OK for stocks," said Peter Berezin, chief global strategist at BCA Research in Montreal.

Ten-year real yields, Treasury yields that adjust for expected inflation, are trading at minus 1% after inflation expectations this month jumped to 2.17%, the highest since May 2018.

One possible beneficiary of rising bond yields could also be bank stocks, Berezin said. "Not only are they cheap, they also are a hedge against a bigger than expected rise in yields."