The rate market crossed two important limits this week. One is that traders see for the first time the US Federal Reserve raising its target interest rate by half a percentage point in each of the next three meetings in May, June and July, marking the biggest such increase since 2000. will mark. The second is that, for a brief moment, the yield on benchmark Treasury inflation-protected securities climbed back above zero.
The fact that both moves would not rule out the possibility of a 75-basis-point rate hike next month should not be lost on financial markets, Federal Reserve Bank of St. Louis President James Bullard said.
It is much more than an outward call by a known hawk. Bullard has been successful in floating test balloons which then turn into generally accepted knowledge. Shortly after Bullard’s comments, a succession of Fed speakers came out in favor of at least one or more half-percentage-point increases, and on Thursday, Chairman Jerome Powell also put his weight behind the aggressive pace of tightening it. Saying that “50 basis points will be on the table for the May meeting.”
It may not be enough just to control inflation. Although policy makers have been successful in propelling markets toward and then hitting their targets, they have been less effective in lowering inflation expectations. Shortly after Powell spoke, 10-year break-even rates, which expect the market to expect inflation rates to exceed the life of securities, climbed to a record above 3% while inflation-protected. Auction of securities strengthened demand. A gauge of Fed-backed inflation expectations rebounded to levels not seen before the market began pricing in several rate hikes. For the Fed to bring the inflation rate closer to its average 2% target from 8.5%, it may need to do more than guide the market and surprise.
To understand just how hard the Fed is facing, look no further than the actual yield, which removes the effects of inflation. After being deeply negative for the past two years, returns on inflation-protected treasuries turned positive and reached the highest level since March 2020.
Still, they remain close to zero, despite nominal yields rising since the Fed’s last rate-hike cycle ended at the end of 2018. As noted by my Bloomberg News colleague Cameron Criss, the 10-year real yield was 1.07%. At that time, more than one percentage point above current levels.
Real returns are a key transmission mechanism for the US Federal Reserve to strengthen financial conditions in markets for equities and credit.
A move above zero would help strengthen the US economy and, by extension, conditions sufficient to control inflation. That’s what happened in 2018, with stocks plummeting that December as the Fed’s rate-hiking cycle plunged.
Importantly, however, the 10-year Treasury yield rose to a little over 3% during that period. For real returns to rise significantly above their current levels, either the 10-year yield—already close to 3%—will have to be raised further or inflation expectations will need to be significantly lowered.
The situation is complicated by the US central bank’s bond-buying program, which has distorted and skewed signals from the US debt market for low-traded inflation-linked bonds, according to the Bank of International Settlements.
This is likely to continue as the Fed begins to exit the market this summer. As my Bloomberg Opinion colleague John Author writes, perhaps a better way to assess where the real return really is is to subtract core inflation from the nominal 10-year yield. It brings you back far below zero.
Right now it is no surprise that traders are still relatively optimistic about further tightening of monetary policy. Consumer sentiment in the US remains healthy and the housing market is proving to be resilient. Conditions in financial markets remain loose and pose a serious threat to stocks not far from their record highs or credits where a healthy stream of corporate bonds deal on tap.
If anything, Bullard’s recent comments mentioned earlier that the US Fed is finally coming around to the idea that if it wants to get inflation back under control, it will have to deal with some blow and possibly some blow to the financial markets and possibly the US economy. Gotta be afraid. Also, by tightening monetary policy more than the market expects—and sooner than later. In that sense, a one-time 75-basis-point increase in the fed funds rate, which the Fed hasn’t done since 1994, isn’t as strange as it might sound.
Jenny Paris is executive editor at Bloomberg News for global bonds, currency and emerging markets.