The Fed and Chair Janet Yellen finally gain the respect of the bond market.

Photographer: Thomas Niedermueller

Bond Traders Finally Start Giving the Fed Some Respect

Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.
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Federal Reserve policy makers have managed to do what the skeptics in the bond market thought was impossible. They regained credibility over a period of three weeks by getting traders to buy into their forecasts of three interest-rate increases this year. But even more impressively, they were able to do that without triggering an all-out bear market. 

This balancing act comes as a surprise to many of us who operate in the trenches, because it followed so many years of miscommunication and unforeseen delays in rate hikes that damaged the Fed’s degree of control over the interest-rate markets. Fed Chair Janet Yellen only has seven more meetings before her term expires in January, but she has corralled a famously dissonant Fed board to speak in unison regarding the need to remove the extreme accommodation still in the system. If this newly earned credibility with the fickle bond trading community is maintained, the markets will continue to hew closely to the narrative, and bond volatility may fall even further in the first tightening cycle since 2004.

New York Federal Reserve President William Dudley laid the groundwork for the reputational recovery three weeks ago when he persuaded the Treasury market that the Fed meant business when they warned that the March Federal Open Market Committee meeting was not only a live one, but a likely venue for a third move in this slow-starting tightening cycle. The turnaround in market sentiment was quite dramatic, with hedge funds conducting massive sales in the market for Treasuries.

Although the Fed had to be pleased that bond traders were finally paying attention to their often-derided forecasts, this group of policy makers has never been a reckless bunch, and they have been particularly sensitive towards triggering severe bouts of volatility in the markets. Their worst fear as they laid out their vision for a faster pace of rate hikes was triggering a repeat of the 2013 “taper tantrum” when bond market suffered a meltdown in response to comments from the Fed that it might soon stop buying fixed-income securities as it wound down its quantitative easing measures. That was no easy task as the risk of another meltdown was increasing. Treasuries were poised to violate some long-held and technically significant support areas, namely the 2.625 percent high in 10-year yields last seen in December.

The Federal Open Market Committee statement hit all the right notes if the Fed’s intention was to calm markets while also suggesting the pace of rate hikes is definitely on the rise. The rate targets for 2017 and 2018 were left unchanged, with only a 0.125 percentage point bump in the 2019 outlook. The assessment of growth language was muted in tone. This moderate approach immediately scared the bearish speculators and their sizable short positions, resulting in an old-fashioned short squeeze that sent bond yields lower.

After managing just two rate hikes in two years, the Fed has now deftly executed two moves in only three months with no visible signs of chaos or disruption in the Treasury market. The Fed’s effective control over the rate-setting process is all the more remarkable given the uncertainty in the Trump administration’s menu of tax, regulatory and infrastructure policies.

The Fed has lowered the bar in terms of economic growth and inflation required to maintain their desired pace of rate increase. While estimates of first quarter economic growth have been sharply marked down towards 1 percent, the strength of the labor markets is undeniable. The Fed forecasts the unemployment rate will fall slightly to 4.5 percent from the current 4.7 percent, as inflation hits their 2 percent target -- a Goldilocks scenario if there ever was one. For now the bond market is buying into this scenario. Bond traders are coming around to the idea that tapping the brakes isn’t the same as locking the wheels up.

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