Surging Inflation May Force Fed to Resort to Yield Curve-Control

The Federal Reserve is at risk of getting schooled in a classic adage: Be careful what you wish for.

Daniel Tenengauzer, head of markets strategy at Bank of New York Mellon Corp., is warning that if inflation gets hotter than the Fed’s new policy is aiming for, it may trigger widespread bond selling that ripples throughout other markets. That may force the central bank to adopt a tool to cap long-term yields -- known as yield-curve control, or YCC, he says.

The latest reading of consumer prices to be released Wednesday is supposed to show a still tepid pace of inflation, and the Fed’s preferred measure holds well below 2%. Even so, U.S. bond-market proxies of future inflation this week have accelerated to the fastest pace since 2014 as traders eye the prospects of more fiscal stimulus and an improving U.S. vaccine rollout. And 30-year Treasury yields eclipsed 2% this week for the first time since February 2020.

“A meaningful upside surprise in realized inflation may, therefore, turn out to be a double-edged sword,” Tenengauzer wrote in a research note. “While a 3% year-over-year CPI inflation overshoot in 2021 would be exactly what the Fed needs to claim ‘mission accomplished’, an ensuing duration selling may trigger a broader market reaction.”

Duration risk in the marketplace is also near record highs, after years of near-zero rates and historic debt issuance -- which leaves both bonds and stocks uniquely vulnerable if yields rise sharply.

Surging Inflation May Force Fed to Resort to Yield Curve-Control

The U.S. 10-year breakeven rate, the yield difference between the benchmark Treasury note and its inflation-protected counterpart known as TIPS, touched as high as 2.216% Monday. TIPS are tied to consumer prices, which have historically exceeded the inflation the Fed targets -- the personal consumption expenditure index -- by about 40 basis points. So the current breakeven rates still imply the Fed will miss its 2% target on average over the next 10 years.

Under a new policy framework adopted last year, the Fed wants an average inflation rate of 2% over time –- which means it could tolerate a higher one for a while.

For 2021, headline CPI will have to be at least 3% for the Fed to consider hiking its policy rate, leaving room for additional duration sell-off, Tenengauzer wrote. January’s measure is projected to show consumer prices climbed last month at a 1.5% annual pace, the fastest since March, according to a Bloomberg survey of economists.

The Fed, which after pondering yield-curve control, or yield caps, last year ultimately backed away from the policy. The central bank continues to buy $80 billion in Treasuries a month as part of its bond-buying programs.

“Moreover, before Federal Reserve officials signaled YCC, we think higher bond yields must be painful enough to trigger financial market distress,” Tenengauzer said.

©2021 Bloomberg L.P.

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