Will 1% Yield Force the Fed Into Curve Control?
(Bloomberg Opinion) -- There’s nothing that whips Wall Street into a frenzy quite like a sharp move higher in U.S. Treasury yields.
For instance, consider this Bloomberg News headline from last Wednesday, when the benchmark 10-year yield touched 0.96%: “Treasury Yield Spike Risks Sparking Domino Effect in Markets.” Investors saw the possibility that stocks would be “vulnerable to a reasonably significant correction,” that the price of gold could stumble and that the dollar might weaken from an already two-and-a-half year low. All this, even though current long-term U.S. yield levels would have been unprecedented just 10 months ago and barely register as a blip on a chart of recent history.
So far, there’s little sign of a ripple effect like the ones in previous years. On Friday, the 10-year yield jumped to as high as 0.9842%, closer to 1% than any time since March, after a middling November jobs report. Stocks nevertheless advanced to record highs.
The sanguine reaction is in no small part because traders expect the Federal Reserve to quickly clamp down on any large and sustained increase in long-dated Treasury yields, which influence everything from mortgages to auto loans to borrowing costs for heavily indebted corporations. Some strategists suggest the central bank will announce such a move to tame the bond market on Dec. 16 by extending the weighted average maturity of the $80 billion in Treasuries it purchases each month. That’s not quite yield-curve control in its purest form, but it effectively sends the same message: We won’t tolerate a selloff of this magnitude.
Is a 10-year Treasury yield of about 1% enough to spook the Fed into action? The answer may depend on which bank’s forecast for 2021 you trust.
I wrote last month about Goldman Sachs Group Inc.’s prediction for next year, which is for a modest increase in 10-year yields to 1.3%. JPMorgan Chase & Co. expects the same. Barclays Plc forecasts the 10-year yield to rise to just 1.25% by the end of 2021, while BMO Capital Markets expects it to hit that mark “at some point” next year, but investors will view it as “an enticing opportunity” to buy. Morgan Stanley sees 1.45% at the end of 2021. Bank of America Corp. says 1.5% for the 10-year note, while the long bond will reach 2.4%, leaving the curve from five to 30 years at the steepest since early 2014.
This would seem to suggest that Treasury yields still have room to run before the Fed would intervene, particularly given that interest rates are increasing because of the prospect of fiscal aid in the short term and a potentially supercharged economy next year. Most bank strategists are forecasting a slow and gradual build to those end-of-2021 levels. In that sense, the world’s biggest bond market is right on track without the central bank doing anything differently.
Meanwhile, the median forecast among 53 analysts surveyed by Bloomberg is for the 10-year yield to end 2021 at 1.15%. TD Securities is among those who expect yields will be lower a year from now, calling for 0.9% for the 10-year note and 1.65% for the 30-year bond. “If monetary policy is now shifting to a role more akin to [yield-curve control], this limits the rise in yields but is not looking to depress them further,” TD strategists wrote in a Dec. 2 report.
The bank’s strategists expect the Fed to announce it’s extending the maturity of its bond purchases in December to achieve this balance:
Central banks have tried to support growth and inflation by taking duration, and thus term premium, out of the market.
The evidence overwhelmingly suggests that QE compresses term premium, precisely one of the mechanisms targeted by central banks to influence the economy. In this context, the long road to recovery from the COVID-induced economic carnage will likely keep asset purchases a key feature of stimulus efforts, especially in the coming months. But … there is an inherent drift in the current policy to see QE purchase less of the net issuance — especially in the US. Our expectation is that the Fed will extend the weighted-average-maturity of Treasury purchases, which would help to prevent a large rise in the term premium, though not push it lower, as other factors work through.
Still, in a BMO survey asking whether the Fed will extend its weighted-average maturity in December, 56% of respondents said no, while 44% anticipate the change will be formalized.
This is a rather unusual rift for a policy move that could have lasting implications for the level of long-term yields and the shape of the curve. In congressional testimony last week, Fed Chair Jerome Powell noted that the central bank was in no hurry to taper its bond buying but also gave no signal that it was ready to necessarily do more, either. He and other officials have made the point that purchasing $120 billion a month of Treasuries and mortgage-backed securities is already a huge sum based on precedent. They won’t have much of a chance to provide more clarity — policy makers are now in their self-imposed quiet period before their decision next week.
One potential wild card: Quantitative strategists at Nomura Holdings warned last week that systematic players known as commodity trading advisors might ditch all of their long positions in Treasuries if the 10-year yield reaches 1.02%. If that happened, the benchmark could quickly jump to 1.2%. The 10-year note hasn’t sold off that much over a calendar week since June.
Jeffrey Rosenberg, senior portfolio manager at BlackRock Inc., said Friday on Bloomberg TV: “93 basis points, 100 basis points, 125 basis points, it’s really about the pace of increase that the Fed will concern itself with. So if you’re talking about in the next six months, a gradual increase in interest rates, I don’t think the Fed needs to react to that. What the Fed would be reacting to would be a very sharp rise in interest rates. Certainly we saw that during the taper tantrum — they react to big moves because that’s disruptive to financial market conditions, to financial market functioning.”
Quant freakout notwithstanding, it’s hard to make a ironclad case for the Fed to rush to extend the average maturity of its bond purchases next week. Across Wall Street, bond traders have been conditioned to expect the central bank to keep short-term rates near zero for the next few years at a minimum and, at least in 2021, not to test the long end too much. At their November meeting, officials discussed updating their forward guidance on the pace of bond buying fairly soon. That seems like the kind of low-hanging fruit that Powell can build consensus around while advocating for additional fiscal aid to anyone who will listen on Capitol Hill.
If 10-year yields glide upward and exceed 1% as a result of such long-awaited fiscal stimulus, it seems like a tradeoff the central bank would be more than happy to make. The Fed’s threat of yield-curve control is enough to keep the world’s biggest bond market in check.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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