Rates rising for 'good reasons' but don't fight the Fed
Powell reaffirms commitment to easy money policies to support still-young recovery.
The recent run-up in intermediate and long-term U.S. Treasury yields has many worrying about how much higher they may continue to rise. The 10-year Treasury is up about 50 basis points this year and is nearing our 1.50% “soft” target for year-end. What has driven this rapid repricing? Accelerating Covid-19 immunizations will unleash pent-up demand for hard hit services (e.g., entertainment, travel and hospitality), boosting the economic recovery. In addition, the massive fiscal intervention related to the pandemic continues to grow as Capitol Hill Democrats are set to use the budget reconciliation process to pass President Biden’s $1.9 trillion Covid relief package without bipartisan support. These two forces—a further reopening economy as the threat of Covid fades and more debt-financed federal spending—are fueling expectations of strong U.S. growth, rising inflation and higher Treasury yields.
That said, a powerful countervailing force cannot be ignored. As Chair Jerome Powell affirmed this week in testimony before Congress, the Fed remains firmly committed to holding short rates at zero for the foreseeable future and to expanding its balance sheet at a massive pace of $120 billion per month. Policymakers have further signaled they’re willing to push those purchases further out the yield curve if long yields rise enough to threaten the recovery and the healing labor market. Near term, inflation may rise on base effects as we lap the deflationary shock of the Covid onset in March 2020, sending major inflation indexes toward or even temporarily above 2% on a year-over-year basis in coming months. Chair Powell, however, remains dismissive of suggestions a permanent breakout is on the horizon, saying that inflation dynamics generally do not “change on a dime” and that “the economy is a long way from our employment and inflation goals.”
To be sure, as reflected by rising inflation risk premiums in the bond market, inflation seems to be simmering with the potential risk of boiling in years to come. The Fed spent decades fighting inflation until it got too low. Are we now on the other side of the coin, with a Fed firmly committed to boost low inflation to the point it may end up getting a bit too much of it? Time will tell. Risk assets have wavered lately on concerns long rates may be setting up for an upside surge, while the Fed’s commitment to keeping rates in check has not wavered. Until that dynamic changes, we’re reminded that it rarely pays to fight the Fed in the short term. In sum, Federated Hermes fixed-income duration committee continues to position for a bias toward higher rates on fiscal and economic expansion, although the Fed’s push back seems likely to slow the pace and magnitude of further increases in the near term.