Fed Stresses Economic Strength, but Muddies the Outlook for Treasury Bonds

The U.S. Federal Reserve held interest rates steady, but failed to ease investors’ concerns about long-term government bonds. It remains unclear how far policy tightening could go and how much extra compensation bondholders will demand.

The Federal Reserve left interest rates unchanged on Wednesday, as expected. However, investors worried about what tighter monetary policy means for long-term government bonds were not reassured by the decision.

Although the central bank described the economy as strong enough to keep inflation elevated, it held back from raising rates immediately. According to analysts, this added to the uncertainty over how far policy could tighten and how much extra yield investors will require to hold long-term bonds, which reached their highest yield levels in twenty years this year.

At its September meeting, the Fed had described economic expansion as “solid”; this time it called it “strong.” It said investment was strong and that job gains were keeping pace with labor force growth. But it was unclear how all this would lead to a decline in price pressures, the main priority for bond investors.

Anders Persson, chief investment officer for global fixed income at Nuveen, believes that if the strong growth Fed Chair Kevin Warsh expects materializes, inflation will remain high as well. In his words, concerns about the budget deficit and its long-term solutions would then become more relevant.

The Yield Curve Steepened

A combination of sustained economic growth and persistent inflation could complicate the U.S. fiscal outlook, limit the Fed’s ability to cut rates when the economy turns down, and keep the Treasury’s borrowing costs high.

After Warsh’s press conference, the yield curve steepened sharply and long-term bonds sold off. The gap between 2-year and 10-year yields widened to 34.1 basis points after remaining stable in recent weeks.

There were several explanations. First, Warsh made no firm commitment on future steps, which reduced bets on a rate hike. Second, he indicated that the Fed’s latest rate increase was starting to take effect and that financial conditions were tightening.

But the steepening points to a deeper tension: on one side, a Fed willing to wait for more evidence before adjusting policy; on the other, investors increasingly worried about persistent price pressures and the burden of long-term government debt.

After the Fed’s decision, Treasury yields rose across most maturities, including 5- to 7-year bonds. Longer-dated bonds remained under particular pressure.

Byron Anderson, head of fixed income at Laffer Tengler Investments, attributed the bond market selloff to the Fed’s difficulty in raising rates higher without causing problems.

Analysts say the selloff in long-term bonds shows that investors are not satisfied with focusing only on the near-term monetary policy outlook; they are weighing inflation uncertainty and the risk that long-term borrowing costs stay high.

Phil Blancato, chief market strategist at Osaic wealth management firm, advises investors to prepare for rates to stay high, since the Fed is focused on returning inflation to its 2% target.

Financial markets are already pricing in the possibility of another hike in December, while expectations of further increases next year add to uncertainty about the policy outlook.

Is the Fed Reading the Economy’s Strength Correctly?

Market participants also questioned the Fed’s assessment of the economy.

Bryan Jacobsen, chief economic strategist at Annex Wealth Management, asks what the Fed is relying on to upgrade its view of the economy. He said the moving average of ADP’s weekly pay data trended upward between July and September, but has been declining since. He also said the Atlanta Fed’s GDPNow forecast has deteriorated “incredibly.”

Some observers believe that even if growth weakens somewhat, the economy need not weaken much to upset the Fed’s upbeat assessment. Andrew Hollenhorst, chief U.S. economist at Citigroup, said Warsh is overstating the breadth of strength in the U.S. economy, so the bar for a surprise is relatively low.

This uncertainty may affect bonds at the front end of the curve more, as they are especially sensitive to rate changes. But pressure on long-term bonds reflects a broader set of concerns.

Why the Term Premium Matters

Investors holding 10- and 30-year Treasuries are more exposed over time to changes in inflation expectations and interest rates. When uncertainty rises, they may demand extra compensation for taking on this risk, which raises yields and pushes bond prices down.

If investors become less sure about the long-term inflation outlook, or demand more compensation for the government’s borrowing needs, the term premium (the extra compensation investors require to hold long-term bonds) can rise even without a corresponding change in expectations for the Fed’s policy rate.

Persson stressed that concerns about pressure on the fiscal outlook are what is driving the long end of the curve.