Grading on a Curve

Bond Traders Detect Fed Error

Central bankers are dampening growth prospects as inflation gain proves elusive.
Photographer: Andrew Harrer

The Federal Reserve is getting closer to making a policy error.

That’s the message bond traders sent on Wednesday when the Fed raised overnight borrowing costs for the second time this year. That was widely expected. What was less anticipated was the signal from U.S. policy makers that they still plan on an additional interest-rate increase this year despite relatively weak economic data of late. At the same time, the Fed gave more details about its plan to start unwinding its behemoth balance sheet later in 2017.

Winter Is Coming

The Federal Reserve is still planning on a third rate increase in 2017; market participants put it more likely at the end of the year

All these moves are aimed at increasing borrowing costs to bring them more in line with historical norms. In the past, the Fed tightened monetary policies to slow growth and tamp down inflation, but that’s not what’s going on here. Instead, U.S. central bankers are clearly worried about easy-money policies fueling a seemingly endless rally in riskier assets and the paucity of ammunition to lower rates the next time the economy sours.

But the bond market’s response showed that the Fed is neither boosting longer-term benchmark borrowing costs nor dampening appetite for riskier assets. Yields on 10-year and 30-year Treasuries plunged after several measures of expected inflation and growth over the longer term fell, and they ended the day lower after the Fed’s announcement.

Yield Plunge

Yields on longer-term U.S. government bonds ended lower after the Fed's decision to raise rates

Source: Bloomberg

In other words, the Fed’s moves have given it little room to drop rates in the future while dimming the outlook for economic expansion in years to come. That looks a lot like a policy error.

The Fed is in a difficult spot right now. Not only is it trying to normalize policies at a time of unimpressive economic growth, but it is doing so as its fellow central bankers in Europe and Asia maintain ultra-easy monetary policies, thus pushing investors into less-creditworthy stocks and bonds. It’s unclear how much power the Fed has to unilaterally squelch this rush to yield, which has pushed valuations to concerning levels.

Still Climbing

Prices for riskier debt have kept rising despite the Fed's efforts to tighten monetary policies

Source: Bloomberg

What these central bankers need to validate their moves is inflation, and that's proving remarkably elusive. Perhaps that’s because oil prices have been relatively low in recent years, but there are also indications that consumers aren’t spending quite as much, another concerning signal for the months ahead.

Narrowing Curve

The U.S. yield curve is flattening as debt traders decrease their growth expectations

Source: Bloomberg

Bond traders are clearly worried that U.S. central bankers are on a path to harm the nation’s prospects for growth without meaningfully adding to its arsenal of tools to deal with any downturn. The debt markets have an uncanny ability to be more right than wrong. It’s worth paying attention to their message.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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