Fed Seen Welcoming Rise in Bond Yields Unless Stocks Take a Hit

Federal Reserve officials probably won’t mind a rise in longer-term interest rates as long as the higher borrowing costs don’t put too much pressure on the stock market.

Yields on 10-year Treasury securities rose above 1% Wednesday for the first time since March and stocks rose to nearly record highs following results of run-off elections in Georgia a day earlier that had Democrats poised to retake control of the Senate.

That would pave the way for more fiscal stimulus, though the scale of additional aid could be tempered by the razor-thin majority Democrats would hold.

Fed Seen Welcoming Rise in Bond Yields Unless Stocks Take a Hit

The Fed has kept borrowing costs at ultra-low levels since the beginning of the coronavirus pandemic to help support the economy and pledged to hold them there until a return to full employment is completed and inflation has returned to 2%. But if interest rates are rising due to improved expectations on Wall Street for economic growth, the U.S. central bank won’t lean against that, Fed-watchers say.

“The market would tell you when it’s too much, and right now the market is not telling you it’s too much,” said Aneta Markowska, chief U.S. economist at Jefferies in New York. “If the market is not worried, why should the Fed be worried?”

The Fed is currently buying $120 billion of Treasury and agency mortgage-backed securities each month to keep a lid on longer-term interest rates. After their last policy meeting in December, Fed Chair Jerome Powell and his colleagues on the rate-setting Federal Open Market Committee issued guidance stating they would continue purchases at least at that pace until the economic recovery had made “substantial further progress.”

Minutes of the meeting, published Wednesday, showed “nearly all favored maintaining the current composition of purchases, although a couple of participants indicated that they were open to weighting purchases of Treasury securities toward longer maturities.”

Financial Conditions

A rise in interest rates that coincided with a decline in stock prices and worsening credit conditions for borrowers in capital markets could lead the Fed to focus its purchases more in the long end of the curve, said Roberto Perli, a partner at Cornerstone Macro in Washington.

“If things don’t go according to their own forecasts, there will be at least somebody in there who brings back the idea of doing more,” Perli said. “The option of extending maturities of Treasury purchases is a very low hanging fruit that costs literally nothing, and could have some -- marginal, maybe, but at least some -- benefit.”

For now, the rise in bond yields and stocks in the wake of the Georgia elections indicate investors see more fiscal stimulus leading to a faster economic recovery, which would allow the Fed to reduce monetary stimulus sooner.

But President-elect Joe Biden and the Democrats may still face an uphill battle in passing a substantial amount of additional relief into law given how slim their majority in Congress will be, according to Neil Dutta, head of economics at Renaissance Macro in New York.

Democrats will take control the U.S. Senate for the first time in six years after media executive Jon Ossoff ousted Republican David Perdue in Georgia, according to NBC and CBS.

Ossoff’s victory splits the Senate 50-50 between the two parties but tips the power in the chamber to Democrats because Vice President-elect Kamala Harris can cast a tie-breaking vote. Raphael Warnock earlier was projected to defeat Republican Kelly Loeffler in Georgia’s other runoff election.

Senate Democratic leader Chuck Schumer says one of the first issues the chamber will tackle is passing $2,000 relief checks for struggling Americans. But that may not matter much to the Fed because it won’t do much to raise the potential for inflationary pressures which would lead the central bank to tighten.

“Let’s say checks go out. A one-time increase in stimulus rebate payments shouldn’t affect longer-run inflation expectations, and therefore shouldn’t really affect the outlook for inflation,” Dutta said.

“I think that they want to engage in passive easing to ensure a credible liftoff from the zero lower bound,” he said, referring to the benchmark Fed policy rate which was slashed nearly to zero in March as the virus spread. “And if you want to do that, then you have to wait longer, and accommodate the loosening of fiscal policy.”

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