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Why the Fed might welcome a bond market tantrum By Reuters


© Reuters. FILE PHOTO. The Federal Reserve Building is seen against the blue sky of Washington, U.S.A, May 1, 2020. REUTERS/Kevin Lamarque/File Photo

By Stefano Rebaudo

(Reuters) – A 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.

Bond markets in the advanced world have a tendency to show persistently low yields. This is due to central banks not being in a hurry raise interest rates, and there being a large global saving glut which keeps bonds securities in high demand.

The starkest contradiction between bond yields and economic recovery is found in the United States.

The 10-year yield on bonds is still at 1.3% despite growth forecasts exceeding 6% and the Fed’s plan to “taper” its bond-buying program at the end this year.

PadhraicGarvey, head research Americas, ING Bank said that the Fed likely rejoiced in low yields for initial stages of recovery. But now, they need bonds to deal with pandemic-linked depression.

Analysts believe that current pricing is more consistent with increased economic uncertainty. However, higher yields will align markets with central bank signals more closely.

We argue there must be a tantrum to facilitate this. Garvey of ING stated, “If the Fed makes a taper announcement… then there isn’t a tantrum at any time, that is in fact a problem for Fed.”

Analysts believe that bond market turmoil would see yields rise 75 to 100 basis points within the space of a few months.

After Ben Bernanke suggested that stimulus would be rescinded, the U.S. yields rose just over 100 points in 2013, the “taper tantrum”.

This sudden rise in yields is unlikely, considering how clear the Fed has been telegraphing its intention to cut back on its bond-buying. Bond market turmoils have negative side-effects, including higher borrowing costs and equity selloffs. This was evident in 2013, as well.

Analysts suggest that benchmark yields could rise from 1.6-1.8% to 30-40 bps, which would make it a more acceptable option.

2013 taper tantrum


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

Fed funds rate, which is the overnight rate that guides U.S. borrowing costs, currently stands at zero to 0.255%. U.S. policymakers are not inclined to increase interest rates, as they do not have the authority to make them negative, like the Bank of Japan or the European Central Bank.

The Fed doesn’t wish to be in the same position as the ECB or BOJ. Their stimulus options are restricted to cutting interest rates into negative territory and buying additional bonds to support 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”.

Effective Federal Funds rate

Another reason higher yields might be welcomed is because banks would like steeper yield curves to boost the attractiveness of making longer-term loans funded with short-term borrowing from depositors or markets.

Pictet Wealth Management’s senior economist Thomas Costerg points out that the Fed funds rate is now at 125 bps, which is much less than the average of 200 bps during economic expansion.

The Fed favors a yield slope of 200bps, he believes. This is not only to validate the Fed’s view that the economy is in good shape but because it is also healthy for maturation transformation.


But even a tantrum might not bring a lasting rise in yields.

The Fed is not envious of New Zealand or Norway, where yields are expected to rise, but it insists that official rates will remain the same for some time.

The Fed must also consider structural factors, including the demand from global investors for the largest AAA-rated bond markets with positive yields.

In theory, the Fed guides interest rates toward the natural rate, which is the rate at which full employment occurs with stable inflation.

This rate has declined steadily. The “longer-run”, the Fed’s proxy rate for natural inflation, has dropped to 0.5% in 2007 from 2.4%. It leaves little room for the Fed if it is correct.

Fed’s natural interest rate

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

It was stated that the natural rate of inflation had been declining because the wealthier, more likely to save money, took a larger share of total income.

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