Federal Reserve Chairman Jerome Powell in front of the Marriner S. Eccles Federal Reserve Board Building in Washington, D.C.
T.J. Kirkpatrick/ReduxThe markets’ thinking about interest rates has gotten rather twisted of late, and they threw a bit of a fit this past week when Federal Reserve Chairman Jerome Powell tried to be straight with them. But could the markets be right?
That twist refers to the yield curve, specifically its increasingly sharp upward tilt, driven by the marked rise in longer-term interest rates. That has lifted the benchmark 10-year Treasury’s yield above 1.50%, from about 0.92% at the turn of the year. More to the point, bond yields are back where they were in early 2020, before the pandemic hit.
The surge in yields gave rise to expectations that Powell, in a Wall Street Journal Jobs Summit interview Thursday, would indicate that the Fed plans to do something to tamp them down. Why this was anticipated isn’t clear, but all he did was essentially reiterate the central bank’s policy stance—although he did allow that the recent run-up in yields had caught his attention.
With payroll employment still 10 million below the prepandemic level, Powell emphasized that the labor market is a long way from the Fed’s goal. And while there could be an uptick in inflation in the months ahead—at least compared with the depressed readings of last March and April—he emphasized that any rise is expected to be temporary. So he repeated the Fed’s intention of maintaining its short-term rate target close to 0% and its monthly purchases of Treasury and agency mortgage-backed securities at $120 billion. Those ultra-easy policies won’t end, he added, until maximum employment is reached and inflation consistently exceeds 2%.
As for the surge in bond yields, Powell emphasized that the central bank watches a broad range of financial indicators. Only a persistent tightening or disorderly swings in financial conditions would cause concern. By implication, he was saying that the backup in bond yields and the retracement in the Nasdaq Composite Index aren’t sufficiently worrisome. Indeed, corporate credit markets remain robust, with booming new-issue volume, while equity conditions are frothy, especially with the explosion of special purpose acquisition companies, or SPACs.
Investors had hoped that Powell would signal a plan to damp the rise in yields, which has dragged down the most richly priced growth stocks. When he didn’t, the disappointment was especially keen among latecomers to the most speculative and hottest exchange-traded funds, which are showing losses.
Perhaps they expected the Fed to follow the example of the Reserve Bank of Australia, which has strenuously leaned against an uptick in yields by defending a 0.10% cap on three-year government bond yields with aggressive purchases. The Aussie central bank has reinforced its intention of keeping monetary conditions easy until its inflation and labor market goals are met, which it doesn’t expect until 2024. That strategy sounds almost as if it were cut and pasted from the Fed’s playbook.
Going back into history, there is precedent for the Fed to peg bond yields. During World War II, it kept longer-term Treasury rates at 2.5% to assist in funding the war effort. Currently, with a record budget deficit that would be widened further by the $1.9 trillion fiscal stimulus package pushed by the Biden administration, more than a few market participants suspect that the central bank might be aiming to help cap the federal government’s future borrowing costs through what amounts to a crude form of modern monetary theory.
That’s been suggested by Mark Grant, chief strategist at B. Riley FBR. As a BofA Securities strategy team, led by Michael Hartnett, writes in a research note, a one-percentage-point rise in Treasury yields would increase Uncle Sam’s annual interest expense by the equivalent of double NASA’s budget. Interest costs one percentage point above the Congressional Budget Office’s baseline estimate would add $9.7 trillion—more than 10 times the annual U.S. defense budget—to the deficit from 2021 to 2030. Such worrisome possibilities, the strategists conclude, make some form of yield curve control inevitable.
The Fed has engaged in “Operation Twist” a couple of times. The first, back in 1961, when the dance craze was at its height, had a minor impact on bond yields. The more contemporary example was from September 2011 to December 2012. During that stretch, a DataTrek research note says, the 10-year Treasury yield dropped to a low of 1.44% in July 2012, from a previous high of 3.75%, although there were a lot of factors at play, including the European debt crisis.
The question now: Will the Fed peg intermediate- and longer-term yields, as it does the overnight federal-funds rate? Deutsche Bank macro strategist Alan Ruskin ticks off a litany of reasons for Powell & Co. to refrain from doing that. As with currency intervention, he warns, pegging is easier to start than to stop. Indeed, BofA’s Hartnett likens Fed yield curve control to the failed pre-euro European Exchange Rate Mechanism of the 1980s and early 1990s, which famously netted George Soros an estimated $1.5 billion after he bet that the British pound wouldn’t stay in the ERM.
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Nevertheless, yield curve control may well be a topic of discussion at the next Federal Open Market Committee meeting, which ends on St. Patrick’s Day, March 17. There is nothing to stop the Fed from shifting its monthly bond buying toward lengthier maturities, but the monetary authorities are unlikely to act immediately. Ruskin suggests that a jump in the 10-year Treasury, to perhaps 2%—which “seriously destabilizes other risky assets”—could elicit some response. But with the S&P 500 index less than 5% below its peak, we’re not there yet.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
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