Bond Traders See the Fed's ‘Third Mandate’ Driving Rates Higher

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Bond traders are wagering that the stock market is driving U.S. monetary policy.

Michael Sedacca, an investment analyst at Rareview Capital, observes that five-year Treasury yields have been marching higher almost in lockstep with the S&P 500 Index. The 90-session correlation between the two has swelled to 0.95 -- the highest on record during a period in which both metrics are trending upwards. The unified movement suggests that investors see the Fed’s interest rate moves tied to soaring equities markets -- the unofficial “third mandate” for policy makers to keep a lid on asset-price inflation.

The reasoning seemed especially pertinent Wednesday, when data showing surprisingly slow inflation was released just hours before the Fed raised interest rates for the third time in 2017.

“What this means is that interest rates, and perhaps by extension Fed policy, is being driven by their ‘financial conditions’ mandate, not inflation,” Sedacca wrote in a note.

The U.S. central bank has a dual mandate to target steady inflation -- defined as 2 percent annual growth in the core consumer-price index -- and full employment, but developments in financial markets are playing an increasingly large role in the pace at which monetary policy makers increase or lower rates. Financial conditions -- as judged by indexes that typically track the U.S. dollar, bond yields, credit spreads and stock prices -- have been improving despite the withdrawal of monetary stimulus stateside, giving the Fed reassurance that its hikes haven’t been dimming the outlook for domestic growth or inflation.

This confluence of yields in the belly of the curve rising in tandem with U.S. stocks implies that investors think this persistent tailwind for activity coming from relatively loose financial conditions is key to the Fed’s plan to normalize policy after years of stimulus. Inflation, certainly, isn’t forcing its hand.

(Updates to show rate decision in third paragraph.)
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