Rising Rates – The Fed’s Conundrum | ETF Trends

The bond market challenged Federal Reserve Chair Jerome Powell last Thursday as 10-year Treasury yields rose to a high of 1.60%, just one day after Powell made it clear that the Fed intends to keep rates low and has no interest in discontinuing quantitative easing.

Thursday appeared to be the perfect storm as the market digested a myriad of headwinds for longer-term bonds in an extremely volatile sell-off. For starters, expectations of potentially better GDP growth brought on by an improved outlook for vaccine distribution coupled with a decrease in COVID deaths likely contributed to the yield curve steepening. Secondly, President Biden’s $1.9 trillion stimulus proposal may have caused inflation expectations to rise, prompting investors to question whether the Federal Reserve will begin tapering sooner than previously expected. Said differently, the market seems to be showing less confidence in the Fed’s plan to keep yields low and let inflation run hot. Perhaps, the spark that lit Thursday’s sell-off was the 7-year Treasury note auction’s bid/cover ratio, hitting a record low of 2.04 %, which signaled a decrease in demand for the security. It is also possible that something more complex is beginning to surface, mortgage/convexity hedging. This type of hedging often happens in the mortgage-backed bond market, where investors sell longer dated treasury bonds to offset the risks of rising rates. The consensus appears to be that no one factor caused the swift move in rates, but a culmination of all the above. After the dust settled, 10 year-yields closed at 1.52 %, nearly 40 basis points higher in just two weeks, exceeding the 99th percentile of all observed changes in that time frame over the last decade. In an economy with total credit-to-GDP at an all-time high, it does not take much of a rise in interest rates to hurt stocks or put pressure on borrowers and the economy. This leaves many to wonder, will the Fed step in to keep rates low on the longer end of the curve?

Based on their reaction to the sell-off, or lack thereof, the Fed seems to be comfortable with the rise in interest rates for now. Globally, we saw Japan’s 10-year yields break to 5-year highs last week. Swiss and German 30-year bond yields were positive for the first time in nearly 18 months. European bank stock prices are breaking out as yields move higher. The European Central Bank said they will remain flexible in purchases across the curve to prevent a tightening of financial conditions. Australia announced record bond purchases to counter the rise in yields. In comparison to its counterparts in other countries, the Fed appears much less opposed to the rise in interest rates for now. As we wait for monthly economic data and commentary from Chairman Powell, we keep in mind the Fed’s goal is to produce a broad-based employment recovery. The consensus is that the Fed will remain dovish, while employment in the most damaged areas of the economy remains weak.

We continue to believe that the Fed’s monetary policy has been the primary driver of what may be a bubble in certain parts of the U.S. equity market. If the Fed gets more aggressively dovish and places a lid on longer term yields, this bubble should remain inflated and may become even larger. However, if long-term interest rates rise, equities could be at risk. Thus, the Fed’s new conundrum.

Sources: FactSet, Bloomberg News, NDR, RENMAC, Strategas. Data and Analytics provided by FactSet. Author: Veronica A. Fulton, Research Analyst – GLOBALT Investments.

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