The Fed Tries to Change the Bond Market Narrative

Despite a recent back up in yields, the market still reflects a "show me" attitude when it comes to growth and inflation.

The Fed needs to update its models.

Photographer: Chris Ratcliffe/Bloomberg

The narrative this year in the market for U.S. Treasuries has been defined by skeptical traders wrestling with the Federal Reserve for control of the yield curve. The Fed has been vanquished in all but a few instances, as the ravenous global demand for high-quality, long-duration assets overwhelms the central bank’s determination to steadily withdraw the excess accommodation that has been in place since the Great Recession.

In fact, bond traders have exhibited domination over all but the very shortest maturities in the Treasury landscape, pushing yields on securities due in 10 years and longer to their lows of the year earlier this month even as Fed looked past slower growth and inflation trends to boost interest rates for the third time since December. The bulls have had plenty of ammunition to bolster their case, as the economy stumbled in the first quarter, China continued its deleveraging efforts, the bear market in oil tamped down inflation fears, and setbacks suffered by the Trump administration in replacing Obamacare added to the notion that crucial tax reform initiatives will be delayed.

The Fed is not without its own weapons in this struggle, and policy makers are now emphasizing a more threatening approach to the exuberance exhibited by riskier assets via a focused campaign to highlight the dangers of frothy financial conditions as a justification for higher rates. In addition to full employment and stable prices, policy makers want markets to believe that this new "third mandate" is necessary to forestall bubbles in stocks and real estate.

This focus on financial conditions is a less-than-subtle reminder that the Fed does not have to amend its rate hike program if the data is weak; it can remove accommodation until the markets get the message that the proverbial punch bowl is going to be taken away regardless. This jawboning seems to be showing some results, as five-year Treasury yields have jumped a significant 18 basis points off their recent lows of 1.67 percent and the relentless flattening of the yield curve has stalled.

The Fed's focus on financial conditions only came after the market showed utter disdain for the central bank's insistence that its plan to increase rates three times in 2017 was on track and that they saw a similar path in 2018 and 2019.

To many bond traders, the Fed under Chair Janet Yellen is seen as hopelessly mired in out-of-date thinking based on a slavish adherence to Phillips curve models. Many are convinced the Fed is looking in vain for signals that the tightest labor markets in a decade will trigger a burst of wage inflation, and the downturn in measures of consumer prices over the past three months only cemented the viewpoint of traders.

While the Fed’s verbal sparring has pushed yields higher and made bonds cheaper, the market still only puts the odds of a rate hike in September at about 20 percent, and puts the chance of an increase in December at about 50 percent. Those lowish odds reflect a show-me attitude from bond traders, who are unconvinced that growth or inflation will rebound as the Fed maintains.

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