Opinion: Bond Market to the Fed: Show Me the Goods
Once again, the bond market is challenging the Federal Reserve’s outlook for the U.S. economy, staking out its own position on where interest rates are headed.
U.S. Treasuries have rallied across the yield curve since the Fed raised the federal funds rate by 25 basis points to a range of 0.75%-1% in mid-March. The yield on the Treasury 10-year note TYM7, fell from 2.64% prior to the rate hike to a low of 2.32% this week.
Two-year notes, which are highly sensitive to the whims of the Fed, appear to be ignoring the prospect for additional rate increases, even with the Fed’s preferred measure of inflation topping 2% in February for the first time in five years. The yield on the two-year Treasury declined from 1.39% on March 14 to a low of 1.23% this week.
Even more noteworthy, fed funds futures prices suggest a high probability of another rate hike by September while a second increase by December remains a toss-up. And that’s with Fed officials talking non-stop about their intention for two, maybe three, additional rate increases this year.
Why is the bond market ignoring the Fed? Getting inside the mind of the market is a tough proposition, not to mention one littered with pitfalls. Sometimes there is a fundamental explanation for why a market does what it does on any given day. At other times, a rally may be driven by technical factors: short-covering, for example, on the part of traders closing out losing positions.
The bond market’s “Show-Me State” behavior, taking a cue from Missouri’s slogan, has been so pronounced over the past few years that it suggests a fundamental underpinning to its actions. Here are a few thoughts on possible explanations for the current rally.
1. All talk, little action
For all its emphasis on the importance of clear communication, Fed talk yields precious little action. Those projected rate increases never quite seem to materialize.
In December 2014, the median projection of the members of the Fed’s policy-setting committee was for a 1.125% funds rate at year-end 2015. The actual funds rate was unchanged at 0%-0.25%.
In December 2015, the Fed’s median projection for the funds rate at year-end 2016 was 1.4% The actual funds rate ended the year at 0.25%-0.50%.
In December 2016, the median projection for the funds rate at year-end 2017 was — you guessed it — 1.4% compared with the current 0.75%-1% range.
So here’s my question. Where would you put your money? With the market or with the Fed?
2. The confidence gap
The yawning gap between soft and hard data — between surveys and actual statistics — will have to be reconciled in coming months. Or split down the middle.
The bond market is clearly betting the resolution will be in favor of the hard data: Nothing exceptional, just more of the same 2.1% average real GDP growth that has prevailed since the recession ended in June 2009.
The stock market has the opposite bet, hoping the Trump reflation trade will eventually pan out.
The divergence between hard and soft data, between stocks and bonds, has gotten a good deal of attention in the financial press.
Less noted is the confidence gap. Business and consumer confidence are soaring, while President Donald Trump’s approval rating is the lowest of any president in the first year of his term. “The ratio between the two is at extremes rarely seen in the last 65 years,” says Jim Bianco, president of Bianco Research.
Last week, the Conference Board reported that its consumer confidence index rose in March to its highest level since December 2000. At the same time, Trump’s approval rating dipped to a new low of 38%, according to Gallup’s daily tracking poll.
Bianco says the only other times the gap between the two measures was so out of whack was in 1973 (Watergate and Arab oil embargo), 1968 (Vietnam War) and 2007 (Iraq War). “In each case, the aftermath was an equity bear market and recession,” he says.
3. Scary new world
At a Brookings Institution conference last month, Federal Reserve Board economists Michael T. Kiley and John M. Roberts presented their findings that the U.S. could be faced with “more frequent episodes of the effective lower bound,” or a 0% fed funds rate.
What constitutes “more frequent”? Forty percent of the time, according to Kiley and Roberts. Under the circumstances, the authors advise allowing inflation to increase at a rate above the Fed’s current 2% target, an idea that has gained advocates in the period since the Great Recession.
In rejecting the Fed’s calls for two or three more rate increases this year, the bond market may just be playing the odds. Heck, 40% is nothing to sneeze at.
4. Positions, positions, positions
When traders get too bearish on bonds, prices can only go up.
That explains some of the recent rally. After reaching extremes at the end of February, large speculators have trimmed their short positions on Treasury notes and bonds, according to data from the Commodity Futures Trading Commission.
Unlike buy-and-hold investors, speculators are looking for quick profits, not safe retirement savings. That’s why many analysts track the positions of large speculators, the “hot money,” to determine how out of balance the market is. In this case, the huge short positions told the story.
5. Portfolio balance
At her press conference following the Fed’s March meeting, Chairwoman Janet Yellen gave no indication when the Fed would begin to wind down its huge balance sheet. A story in Saturday’s Wall Street Journal hinted at a time frame: “possibly later this year.”
The immediate effect of allowing assets to mature or outright sales is uncertain. That’s because banks are holding $2.2 trillion in excess reserves, above and beyond what they are required to hold against certain types of customer deposits. The Fed’s sale of Treasury and mortgage-backed securities would not have the same contractionary effect, putting upward pressure on the funds rate, that it would have if the banks had to pay for those securities with their required reserves.
The bond market is one tough customer. In an age of increased central bank transparency, the market insists on challenging the Fed at every opportunity, asserting its independence and Missouri heritage, and daring the Fed to “show me” the goods.