The Fed and the bond markets

JEROME POWELL does not want you to misunderstand him. The Chair of the Federal Reserve knows that communication is a big part of how monetary policy works. Mr Powell speaks plainly. He is not an economist, but that probably helps, because he is less likely to resort to confusing jargon. His messages at the Fed’s press conference on March 17th were admirably clear: no change in the main policy settings; no change in Fed guidance about future shifts in policy; and no real concerns about jumpy government bond markets.

That latter message might seem a little surprising. The sharp and volatile rise in the yield on ten-year Treasuries since the start of 2021 has been routinely compared to the “taper tantrum” of 2013, when markets threw a fit in response to hints that the Fed would reduce (or taper) its bond purchases. This year’s volatility has been construed by many investors as a challenge to the Fed. Yet Mr Powell was unperturbed. And why not? Looked at in the round the markets have been remarkably compliant.

They will not always be so. At some stage, the Fed will shift gears and announce that it is going to taper. Lessons have been learned from 2013 about how not to spook the markets. But the idea of immaculate forward guidance by the Fed, in which markets are never taken by surprise, still seems fanciful. A bond market capable of a taper-less tantrum is unlikely to deliver a tantrum-less taper.

In one sense, the rise in Treasury yields has been quite natural. In the early stage of the business cycle, as confidence in economic recovery builds, investors start to demand greater compensation for holding long-term bonds. The big upgrade to GDP growth forecasts this year merits a big rise in yields. Expectations of inflation derived from bond prices are now almost rigidly in line with the Fed’s target of 2% on the personal consumption expenditures (PCE) index.

In this sense, the market has been obedient. Even the stockmarket is going Jay’s way. After a surge in equity prices through last year, the S&P 500 index has lost momentum. There has been a lot of action within the index, though. Some of the froth on the more faddish stocks has been blown off. Meanwhile the cheap-looking shares of “cyclical” companies, which profit from economic recoveries, have gone up in value. If Mr Powell seems fine with all this, it is understandable. It is a validation of sorts.

Bigger challenges lie ahead. Mr Powell says that the preconditions for the Fed to raise interest rates—full employment, inflation moderately above 2% for a while—are some way off. But before then, the Fed will taper its bond-buying. There will be an element of discretion to its decision to start. When it comes, it will mark a gear-change in monetary policy. That alone will be unsettling. Ideally the Fed would allow for longish pauses between its signal to taper, the taper itself and the first interest-rate rise to allow markets to settle.

It may not get the chance. Everything in this economic cycle is happening at great speed. That is in part a reflection of the scale of economic stimulus, and not only from the Fed. One big fiscal package seems set to follow another. A $1.9trn package has barely passed and a $3trn infrastructure bill is mooted. The Fed may be pushed to go through its paces faster than it would prefer.

Speedy policy shifts cause tantrums. One reason to think the market might be touchier than normal is related to how far asset prices, particularly of risky securities, have risen given the business cycle is still young. The housing market has recovered smartly. Struggling firms that rushed to issue bonds in a frenzy last year are under less pressure than they normally would be to reduce their debts. Spreads on risky corporate bonds are remarkably tight. And America’s stockmarket is once again trading at a lofty multiple of earnings. All of this increases the sensitivity of the economy to the Fed’s next policy shift.

That is probably not soon. The Fed has bought itself some breathing room by insisting that the inflation that accompanies reopening over the next few months is likely to be prove transitory. The message from Mr Powell is that he and his colleagues are not even talking about talking about tapering. “Until we give you a signal, you can assume we’re not there yet,” he said. But we might get there by the end of this year or early next year, given how quickly things are moving. Mr Powell’s signalling has been admirably clear, so far. But there will be plenty of scope for misunderstandings later on.