US bond market in divergence with Federal Reserve intentions
Investors retain the firm belief that rate hikes will take a longer time coming
The US bond market may downplay the chance of interest rate rises arriving this summer; not so Janet Yellen.
The chairwoman of the US Federal Reserve has signalled that the central bank desires greater flexibility in terms of ending its current policy of maintaining near zero borrowing costs, introduced more than six years ago during the depths of the financial crisis.
Now with the US economy generating solid job gains, with the creation of more than 1m new positions since November, the stars are aligning for a normalisation of interest rates that could arrive in June and not later in the year, as forecast by the bond market.
The dawning prospect of the first US rate rise since 2006 remains a major point of uncertainty for how markets may perform this year. The bond market has long reflected a view that rate increases will be gradual and limited in scope, with investors focused on falling inflation pressures and an uncertain global backdrop.
Solid demand for new twoyear notes sold after the latest Fed testimony on Tuesday resulted in the policy-sensitive yield dropping back below 0.6 per cent, illustrating how the bond market remains sanguine about the risk of rate rises.
Meanwhile, the S&P500 reached a new record closing high, with markets soothed by the Fed chief stressing that any shift away from saying policy can remain “patient” before raising interest rates does not signal imminent liftoff from near 0 per cent.
Ian Lyngen, strategist at CRT Capital, says the Fed can remove “patient” from its policy statement at next month’s meeting, without necessarily “signalling that tightening is a ‘couple’ of meetings away”.
Wage growth
Once the Fed drops its patient stance, however, rate rises could well arrive this summer should wage growth pick up and other indicators improve.
Yellen downplayed falling inflation and excess capacity, suggesting policy remains on hold for much of this year, and focused on the likely boost in growth from lower oil prices and a strengthening jobs market. Global concerns and low long-term market estimates of inflation have supported a divergence over the extent of rate increases between the Fed and bond investors.
A central bank looking to push overnight borrowing costs beyond 1 per cent by the end of this year continues encountering scepticism from a market that expects a level about 0.5 per cent. A volatile summer could well ensue should the Fed decide to act sooner than assumed by bond traders.
“It does potentially set up a difficult reaction in the bond market if the Fed does follow through with a June rate hike,” says Anthony Valeri, investment strategist at LPL Financial. “The bond market simply isn’t priced to expect a June rate hike.”