Fed takeaway: yields are heading higher Fed takeaway: yields are heading higher http://www.federatedinvestors.com/texPool/static/images/texpool/texpool-logo-amp.png http://www.federatedinvestors.com/texPool/daf\images\insights\article\skyscraper-modern-building-small.jpg March 18 2022 March 17 2022

Fed takeaway: yields are heading higher

Policymakers don't want to undo 40 years of restrained inflation expectations.

Published March 17 2022

“To get real yields back in the direction of zero, the Fed needs to raise short rates, nominal U.S. Treasury yields need to rise and/or inflation must decline sharply.”

It wasn’t a shock, but the Fed did surprise the market, forecasting the median terminal federal funds rate to hit 2.75% in a hiking cycle that lifted off this week. That’s well above the median long-run neutral rate of now 2.375%, down from 2.50% at prior Fed meetings. This signals policymakers’ intent to get the inflation genie back in the bottle. Add in planned balance sheet reduction—Powell said that could start as early as the next meeting—and U.S. Treasury yields appear almost certain to continue their rise.

How much depends in part on what comes next on the geopolitical front. The Russian/Ukraine war is aggravating the inflation problem. Despite recent pullbacks, the spike in oil, natural gas, critical metals and agricultural commodities brought on with the conflict’s onset is still working its way through the pipeline. This negative aggregate supply shock is certain to slow growth to varying degrees throughout the world. The unknown is how much. Recession in parts of Europe is possible. In the more insulated U.S., it’s less a question of imminent recession than whether financial conditions tighten and growth slows sufficiently to do some of the Fed’s work for it, warranting a potentially lower endpoint for the Fed’s tightening cycle.

What is clear is that the Fed wants to prevent higher inflation expectations from becoming entrenched. In this highly uncertain geopolitical and macroeconomic environment, the Fed leadership plans to hike steadily by a quarter point at every meeting this year and to soon begin paring the Fed’s massive balance sheet, all the while assessing how the markets, the economy and inflation react and the war evolves. Incremental progress toward some de-escalation in Ukraine and the rising likelihood of a revived Iranian nuclear deal have supported recent declines in oil prices. If that continues, it could help diminish the aggregate supply shock. 

With Treasury market yields still sharply below current and expected rates of inflation, real yields are at historic negative levels in the U.S. To get real yields back in the direction of zero, the Fed needs to raise short rates, nominal U.S. Treasury yields need to rise and/or inflation must decline sharply. The Fed this week clearly established its intent to raise short rates, and Treasury yields already have climbed sharply this year, with the biggest increases on the short-to-intermediate end. So, how does inflation behave in quarters and years to come? If it does not decline markedly, then the levels of Fed short rates and Treasury yields must rise more, raising the risk of a recession in coming years. If that happens, the markets will reassess. For now, we think markets will remain focused on the Fed and inflation, driving yields higher, with recession risks/concerns simmering on the back burner.

Tags Monetary Policy . Interest Rates . Fixed Income .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

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