Bond Market Finally Extending the Fed Some Respect

The Treasury’s quarterly refunding this week will get extra attention.
Mark Wilson/Getty Images

Bond traders have been hyper-focused on the monthly U.S. employment report for decades, but in this oddly quiet limbo period in the Treasury market, the traditional economic yardsticks used to gauge value in fixed-income assets may be less important than one crucial intangible: the toughening of the Federal Reserve’s spine. 

Friday’s mixed bag of payroll statistics initially triggered a powerful rally in Treasuries, as disappointed hedge funds and leveraged speculators scrambled to cover their short positions. Although the 227,000 increase in jobs was robust, sluggish average hourly earnings growth of 0.1 percent initially won out on the idea that it surely won’t spur the Fed to accelerate what has been a glacially slow removal of accommodation.

But then the narrative shifted, and in a manner that suggests this Fed is finally gaining the credibility with the market that it has squandered away over the past several years amid stop-and-start policy mishaps.

To understand what is happening now in the bond market, it’s important to recall that Chair Janet Yellen has been criticized for her delay in acknowledging the steady improvement in the labor market as the jobless rate fell to 4.7 percent, from double digits in the aftermath of the financial crisis.

Yet her insistence that the labor market had plenty of slack has become increasingly untenable, and the Fed’s most recent statements made it clear that the wide divisions between the doves and the hawks at the central bank have mostly disappeared. The consensus among the policymakers at the Fed has clarified: 2017 should see a much faster pace of three 25-basis-point rate hikes, as growth and inflation have steadily improved towards the Fed’s long-term goals.

San Francisco Fed President John Williams, seen as a consensus figure on the Federal Open Market Committee that sets monetary policy, then came out on Friday and managed what many Fed talking heads have failed to do since the central bank signaled an end to the zero-rate era: He actually talked the bond market lower! Williams insisted that the March meeting was still a live one, and that there is a real risk of the Fed moving too slowly as inflation pressures build. 

The tone of the Treasury market shifted abruptly. That’s significant because the skepticism regarding the Fed’s toughness was a given over the past few years. “Lower for longer” strategies toward rates were repeatedly successful, and the Yellen Fed was assumed to be so dovish that the nominal targets for a neutral rate were widely mocked. The market’s steady pricing of roughly two hikes for 2017 and Friday’s Williams-induced reversal suggest that this Fed is slowly regaining credibility.

Traders aren’t yet willing to price in the three rate increases, but for this doubting bunch of speculators, two hikes represent a radical shift in their belief structure. The Fed’s willingness to stick with the program appears immune to the day-to day confusion surrounding the White House tax and spending plans, and the quick executive action last week on regulatory reform cheered the economy bulls as well.

Even as the Fed’s warning shots have more immediate impact, they won’t induce many investors to gamble on a rate hike as soon as March. The odds still fluctuate around 10 percent to 20 percent, based on market prices. More likely is a move in June, followed by another sometime in the final four months of the year.

This week the market will shift its sights away from the Fed and the data calendar and will focus on the $62 billion Treasury refunding. Hints of higher rates abroad have led to doubts concerning overseas demand for dollar-denominated bonds. The 10- and 30-year auctions on Wednesday and Thursday will be a key test of the depth of the Treasury market.

The more credible this Fed becomes, the harder it will be to induce investors into aggressive bond-buying. This Fed threat is also becoming more real just as the markets fear an explosion in Treasury financing needs as the Trump fiscal boosts are implemented. Treasury investors have gone into winter hibernation for the past few months, but for the bond vigilantes, the “spring awakening” could be theatrical.

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

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