Analysis: Why the Fed might be celebrating a bond market crisis

September 20 (Reuters) – A bond market crisis that pushes up yields may be a daunting prospect for central banks, but the US Federal Reserve may well be celebrating a sell-off that would push Treasury yields to levels reflecting better the robust state of the economy.

Consistently low yields are a hallmark of bond markets in the developed world, with central banks mostly in no rush to raise interest rates and a glut of global savings keeping debt securities in constant demand.

But it is in the United States that the contradiction between economic recovery and bond yields is most glaring.

Even with growth estimated at over 6% this year and a “taper” in sight for the Fed’s bond buying program at the end of this year, 10-year yields are still stuck at just above. by 1.3%. . Read more

The Fed likely welcomed the low yields at the start of the economic recovery, but now needs bonds to meet the end of the pandemic-related recession, said Padhraic Garvey, head of research for the Americas at ING Bank.

Current prices, analysts say, appear more compatible with heightened economic uncertainty, as higher yields would align markets more with signals from central banks.

“To facilitate this, we argue that there must be a crisis. If the Fed has a cut announcement… and there is no crisis at all, it’s actually a problem for the Fed.” , said Garvey of ING.

Analysts say a bond market slump would cause yields to rise 75-100 basis points (bps) in a matter of months.

The initial 2013 “taper tantrum” boosted US yields by just over 100 basis points in the four months after Fed boss Ben Bernanke hinted at an unwinding of stimulus measures.

But that kind of sudden surge in yields seems unlikely at this time, given the clarity with which the Fed has telegraphed its intention to cut its bond purchases. And as 2013 showed, bond market crises have unpleasant side effects, including higher equity sales and higher borrowing costs around the world.

A happy medium, analysts say, could be for benchmark yields to rise 30-40 basis points to 1.6-1.8%.

THE FED AND THE BANKS NEED AMMUNITION

In addition to wanting higher yields to better reflect the pace of economic growth, the Fed must also salvage ammunition to counter future economic downturns.

The federal funds rate – the overnight rate that guides U.S. borrowing costs – is zero to 0.25 percent, and U.S. policymakers, unlike the Bank of Japan and the European Central Bank, are shy. inclined to consider negative interest rates.

The Fed will not want to find itself in the position of the ECB and the BOJ, whose stimulus options for now are limited to cutting rates further into negative territory or buying more bonds to guarantee government spending.

Jim Leaviss, investment manager at M&G Investments for public fixed income, said policymakers would probably like the federal funds rate to be 2%, “so when we get into the next downturn the Fed will have a little space to reduce interest rates without quickly reaching the lower limit of zero “.

Another reason that higher yields might be welcome is that banks would like steeper yield curves to increase the attractiveness of long-term loans funded by short-term borrowing from depositors or markets.

Thomas Costerg, senior economist at Pictet Wealth Management, notes that the spread between the Fed funds rate and 10-year yields of around 125bp is now well below the 200bp average seen in previous booms. economic.

He thinks the Fed would favor a 200bp yield slope, “not only because it would validate their view that the business cycle is good, but also because a 200bp slope is healthy for the transformation of the sector’s maturities. banking”.

GRAVITATIONAL FORCE

But even a tantrum might not lead to a lasting rise in yields.

First, while the Fed may look longingly at Norway and New Zealand where yields have risen pending rate hikes, it has stressed that its own official rates will not rise for some time.

Structural factors are also at play, including global demand for the only major AAA-rated bond market with positive returns.

The Fed also shifts rates, at least in theory, towards the natural interest rate, the level where full employment coincides with stable inflation.

But this rate has steadily declined. Adjusted for projected inflation, the “longer-term” fund rate – the Fed’s proxy for the natural rate – fell to 0.5% from 2.4% in 2007. If it is correct, it leaves little room for maneuver for the Fed.

Demographics and slower trend growth are cited as the reasons for the fall in the natural rate, although an article presented last month at the Jackson Hole Symposium also blamed an increase in income inequality since the 1980s.

The newspaper said the rich, who are more likely to save, take a larger share of overall income and the resulting savings glut is weighing on the natural interest rate.

“One lesson from this year is that there is a massive gravitational force, price insensitive demand weighing on Treasury yields,” said Costerg of Pictet.

Report by Stefano Rebaudo; Additional reporting by Dhara Ranasinghe in London and Dan Burns in New York; Editing by Sujata Rao and David Clarke

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