The bond market dismisses the FOMC’s hawkish signals

The bond market dismisses the FOMC’s hawkish signals by Saxo Group
The bond market’s reaction was muted amid a hawkish Federal Reserve’s meeting. Investors decided to focus on shorter-term economic dynamics such as the Delta variant dismissing signals of aggressive tapering and a Fed fund rate forecast of 1.8% for 2024, much higher than the Euro Dollar market pricing. Bond yields are likely to trade rangebound between 1.26% and 1.4% until it’s evident inflation will not be transitory. Dropping longer-term yields drive the flattening of the yield curve, posing a problem if the central bank needs to hike interest rates soon. Tapering should help to steepen the yield curve unless US economic data continue to come in weak, pinning down long term yields.

In light of yesterday’s FOMC meeting, the muted market reaction indicates that investors continue to focus on shorter-term economic dynamics such as Delta and employment rather than on inflation.

However, we believe that the Federal Reserve was relatively dovish yesterday:

  • It implied that tapering might be aggressive as it will possibly start as soon as November to finish by June next year. Powell even added that if needed, they’d speed up the tapering before rising rates. It shows that the Fed opens up to be even more aggressive depending on upcoming inflation readings. Also, half of the members see rates rising already in 2022 instead of 2023.
  • For the first time, it introduced a Fed funds rate forecast for 2024 of 1.8%, which is well above what the market expects in the eurodollar strip.
  • It significantly raised the PCE forecasts for 2021 to 3.7% from 2% in June, and for 2022 and 2023 to 2.3% and 2.2%. It shows that the central bank is beginning to resonate with the fact that inflation might end up being higher than their 2% target for a more extended period. When asked, Powell said, “if sustained higher inflation were to become a serious concern, the Fed would respond”. It sounds like that not only tapering could be more aggressive, but that interest rate hikes might start closer to the tapering end date, opposite to what was previously stated.
  • The dot plot showed that more members see rates rising already in 2022 instead of 2023 from the previous meeting.

How did the bond market react to yesterday’s FOMC, and what is it telling us?

The yield curve flattened considerably, with the 5s30s year spread falling below 100bps for the first time since August last year.

The flattening was driven by 30-year yields dropping 4bps on the day, while 5-year rose only by 2.5bps. Longer-term yields dropped faster than shorter-term yields showing that the market is somewhat concerned about the Fed making a policy mistake.

The problem with dropping long-term yields is that if interest rates need to be hiked soon, it would be best for the yield curve to be steeper to avoid an inversion if the front part of the yield curve rises fast. In that respect, tapering should help unless US economic data continue to come in weak, pinning down the long part of the yield curve.

Today’s preliminary PMI indexes could confirm the market’s cautious stance if they come in weak as in August. Thus, bond yields might not move much until the next inflation read, trading rangebound between 1.26% and 1.4%.

Topics: Bonds Government Bonds Corporate Bonds Bond fund Bond Government bond Federal Reserve Central Banks Inflation Focus Inflation United States USD EURUSD

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