Bond traders see crack in Fed’s re­solve about in­fla­tion

Flat­ten­ing yield curve in mar­ket dom­i­nant trend an­tic­i­pated

The Star Malaysia - StarBiz - - Front Page -

NEW YORK: Traders are about to find out just how wor­ried Fed­eral Re­serve of­fi­cials are about the out­look for in­fla­tion. The depth of that angst has ram­i­fi­ca­tions for the US bond mar­ket’s dom­i­nant trend: the flat­ten­ing yield curve.

Fed chair Janet Yellen and the nom­i­nee to suc­ceed her, Jerome Pow­ell, lead a busy lineup of cen­tral bankers speak­ing this week.

They may opine on in­fla­tion af­ter min­utes of their most re­cent meet­ing pub­lished last week showed sev­eral pol­icy mak­ers were con­cerned about low ex­pec­ta­tions for con­sumer-price gains and un­der­scored that fur­ther in­ter­est-rate hikes will hinge on eco­nomic data.

It’s only fit­ting, then, that the Fed’s pre­ferred gauge of price growth will also be re­leased this week, with a sur­vey of econ­o­mists in­di­cat­ing it’s likely to slow to a 1.5% year-on-year pace.

For the bond mar­ket, the ex­pec­ta­tion of fur­ther rate hikes amid be­low-tar­get in­fla­tion has big im­pli­ca­tions.

It’s been per­haps the key rea­son why the US curve has flat­tened in the past month at the fastest pace in nearly three years.

That com­pres­sion has al­ready elicited re­sponses from some Fed of­fi­cials, and in­vestors will be at­tuned to any in­di­ca­tions from Pow­ell or Yellen about how that might af­fect their think­ing. Af­ter the min­utes, traders may ques­tion the Fed’s re­solve anew, pon­der­ing whether they were wrong to push two-year Trea­sury yields to the high­est level since 2008.

“We are start­ing to be­come afraid that a few Fed in­fla­tion scaredy cats will grow to many more Fed of­fi­cials next year if core PCE in­fla­tion does not start show­ing some signs of mov­ing up,” Chris Rup­key, chief fi­nan­cial econ­o­mist with MUFG Union Bank in New York, wrote in a note Nov 22.

“One thing is for sure, the Fed is more data-de­pen­dent than ever, and the key data are in­fla­tion.”

The bond mar­ket isn’t go­ing as far as tak­ing the lat­est fret­ting among pol­icy mak­ers as rea- son to aban­don bets on a De­cem­ber rate hike.

The im­plied prob­a­bil­ity of an in­crease next month is more than 90%, based on overnight in­dex swaps and the ef­fec­tive fed funds rate. But in­vestors are once again tem­per­ing their en­thu­si­asm about the cen­tral bank’s abil­ity to stoke con­sumer prices in the longer term, with so-called breakeven rates on in­fla­tion-linked bonds dip­ping.

The dol­lar’s fledg­ling rally also came to a halt with the cur­rency drop­ping to an al­most two-month low af­ter Yellen cau­tioned about al­low­ing in­fla­tion to drift lower.

Yellen and Pow­ell will both be in Wash­ing­ton this week. Yellen goes be­fore the joint eco­nomic com­mit­tee of congress, while Pow­ell ap­pears at the sen­ate bank­ing com­mit­tee as part of his con­fir­ma­tion process.

Since the Fed’s Nov 1 de­ci­sion, the yield curve from two to 10 years has flat­tened by 15 ba­sis points and is now close to the lowest level in a decade.

Fed of­fi­cials in­clud­ing James Bullard and Robert Ka­plan have given their views on the trend in the curve since then and they’re on tap to speak again this week.

Traders will mon­i­tor all of these speak­ers with one ques­tion in mind: af­ter a year in which the Fed has largely stuck to its script, will in­fla­tion drive pol­icy mak­ers to im­pro­vise?

One thing is for sure, the Fed is more data-de­pen­dent than ever, and the key data are in­fla­tion. Chris Rup­key

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