There seems to be a fair amount of surprise and confusion surrounding today's bond market sell-off in response to Fed Chair Powell's Q&A with the WSJ. First off, this wasn't a Q&A so much as a PSA to address some fairly far-fetched assumptions about how the Fed might react to the recent spike in bond yields. It's a sad state of affairs that such an exercise was even necessary considering just how transparent and unified the Fed has been in their message. What message is that? Here are a few of the key points laid out by multiple Fed speakers recently:
- Rising long-term bond yields are not yet troubling. They reflect economic optimism and rising inflation expectations. This is what should be happening at this stage in the recovery
- The Fed discussed extending the duration of its bond holdings (aka "operation twist") as a potential policy tool near the end of 2020 and unanimously concluded that it wasn't the right tool for the job--especially in light of fiscal stimulus expectations at the time. There has been no meaningful discussion of 'twist' or anything like it in recent meetings and speeches, and no reason to believe the Fed's stance on 'twist' would have changed in the past few weeks
Nonetheless, for whatever reason, expectations sprouted up seemingly overnight regarding the twisty potential. Mainstream media and contrarian blogs were equally complicit and equally off-base. Unfortunately, that sentiment had crept into playbooks of some market participants in the past 2 days. Here's how I characterized it this morning:
"Long story short, some of the voices in the market seem to have greatly overestimated the Fed's willingness to "twist." To whatever extent those voices represent current trading positions, bonds could have a rough afternoon."
A rough afternoon is a good way to describe it. It wasn't catastrophic, but it wasn't gentle. Yields spiked to 1.554% (and are still near that), up from 1.45% earlier today. That means there were quite a few bets being made on Powell saying something more bond-friendly, even if those bets weren't explicitly on the enactment of a new Operation Twist.
What else did Powell say that could have contributed to the weakness? One could argue it was mostly about what he DIDN'T say (despite numerous softballs lobbed into the strike zone by WSJ's Timiraos), but there were several tidbits that probably didn't help. Here's a bullet-point run-down, in no particular order (some of these are bond friendly, to be fair, so let's separate them accordingly):
- still a long way from Fed's goals
- inflation increases likely to be one-time
- will take some time to get back to full employment, lots of ground to cover.. very high standard for identifying "max employment" (would need unemployment rate well under 4%... highly unlikely by this year)
- Rate lift-off guidance is pretty specific, and will take some time to get there. Economy would have to be "all but fully recovered"
- Won't raise rates just to cool off labor market. Need inflation too.
- Haven't been making much progress on our goals
Not Bond Friendly
- good reason to expect job creation to pick up in coming months
- as economy improves, inflation will pick up
- would be concerned IF we didn't see orderly conditions in financial markets (<---That's the kicker!)
- WOULD BE concerned by persistent tightening of financial conditions
- Current policy stance is appropriate
- If conditions change, we'll use our tools to address
- It's good to be where we are relative to what we expected a year ago
- Financial conditions are highly accommodative
Before we move on, what does the Fed mean by "financial conditions?" In a word: stock prices and interest rates. Are stocks high? Are rates low? If so, financial conditions are accommodative. There's some implicit reference to smooth market functioning here as well (i.e. is there liquidity in the secondary bond market). So by saying financial conditions are accommodative and that they're not currently seeing a lack of "orderly" conditions in financial markets, Powell is saying stocks are high, rates aren't too high, and money is moving like it should between investors. Period. The End. Simple.
For market participants who were sure Powell would have more of a sense of urgency regarding the recent rate spike, this was enough of a surprise to sell some bonds. The sell-off leaves the recent yield ceiling at 1.62% very much intact, but also very much reinforces a sea change that is underway in the past 5-8 weeks.
It is very important to you understand this 'sea-change.'
While there are plenty of differences between now and 2013 (or 2016), there is a ton of similarity in the sense that the entire bond market is tasked with a widespread REPRICING of expectations about what the future will hold. The market is pricing OUT a reality where covid crushes the global economy in an unrecoverable way (that's what 10yr yields of 0.50% were for) and pricing IN a reality that's, at the very least, less dire.
The new reality consists of global herd immunity to covid within 2 years, a massive amount of fiscal and monetary stimulus in the meantime, and the possibility of one of the largest mass migrations of displaced workers back into the workforce that's ever happened or ever will happen in modern economic history (yes, the jury is still very much out on the last one, but the Fed continues to allude to a contingent of parents who are not currently working due to a lack of in-person schooling and daycare options).
When the Fed chair has an opportunity to say "yeah, you know those higher rates really are a bummer, and we probably don't want to let them get too much higher," and instead says "long ways to go, but things are going great and financial conditions are accommodative," it stands as an unequivocal endorsement of the sea-change at the most important level... well... second most important level behind the official counts of covid cases and vaccine distribution.
Either way, yields only had business under 1.0% when traders were pricing in a future economic reality that now looks to have been ruled out. It was and is clear that yields needed to move higher as cases plummet and vaccines are increasingly available (and that mortgage people were at risk of getting caught off guard due to mortgage rate resilience in 2020--something I warned about so much that you're probably tired of being reminded). What wasn't clear is exactly how quickly or how significantly yields needed to rise.
Certainly, it's more than fair to treat the previous all-time lows (before covid) of 1.32% as some sort of general line in the sand (remember, it's not about whether covid creates lasting economic damage as much as it's about the trajectory of the economy, the pace of Treasury issuance, and the risk that the Fed no longer needs to buy $120bln of new bonds every month in addition to reinvesting its existing portfolio).
In fact, with all that "stuff" in mind, even this morning's 1.46% felt low. In fact, this afternoon's 1.54% is still low in that context. Why aren't they higher already then? Bottom line: bonds aren't ever going to instantly get where they think they need to go, but it doesn't mean they're not on their way. If that scares you, the saving grace is that by the time they would get there, new realities often come to light that help push back in the other direction. Considering this sell-off has been going on since August 2020, pretty soon it won't be "too soon" to look for that pushback.