Federal Reserve policy: Mending an inflation misread
After falling desperately behind the inflation curve, the Federal Reserve has finally recognized the urgent need to tighten policy. An incoming wave of policy rate hikes, coupled with balance sheet reduction and sustained price pressures, mean bond bulls will remain under pressure for the foreseeable future.
Implied fed funds target rate and market expectations
FOMC member projections and fed funds futures
Through most of 2021, conditioned by the past decade where deflation was a far greater concern than inflation, the Federal Reserve (Fed) remained convinced that the spike in price pressures would prove transitory and that they wouldn’t need to raise rates until 2023.
Recently, however, with price pressures intensifying and broadening out to stickier items such as wage growth and shelter costs, and inflation expectations moving higher, the Fed has finally recognized its erroneous read of the inflation situation. In the space of nine months, the Fed’s own expectations for policy rate tightening in 2022 moved from 0bps to 190bps. Market expectations have moved even further, from 0bps to 275bps, plus a further 100bps of tightening anticipated for 2023.
The impact on bond markets is clear: Before a re-intensification of Russia/Ukraine tensions recently intervened to increase demand for safe haven assets, 10-year U.S. treasury yields had been heading inexorably toward 3%, a 125bps rise since the start of 2022.
The fundamental drivers of this parabolic move are still very much intact. Sharp policy hikes, including the first 50bps increase since May 2000 and potentially the first back-to-back 50bps hikes since 1984, together with balance sheet reduction and sustained price pressures, will keep yields elevated for the foreseeable future. Bond bulls have been finally laid to rest.
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