Interest rate expectations from Federal Reserve officials drew mixed reactions from US bond markets on Wednesday, indicating that investors still had questions about the size of the central bank. In fact, monetary policy will be tightened.
The sell-off in short-term Treasuries indicated that investors once again raised their expectations of how much interest rates will rise this year. The initial sale of long-term bonds quickly faded, a sign that investors believed that the rapid pace of interest rate increases over the next several months could lead to smaller increases later.
Stocks jumpedThe S&P 500 rose 2.2% and the heavy Nasdaq Composite rose 3.8%.
Matching investors’ expectations, the central bank on Wednesday raised the benchmark federal funds rate from nearly zero to a range between 0.25% and 0.5%. Despite this, officials have dramatically raised their expectations of how high rates will rise over the next two years.
Overall, 12 out of 16 officials indicated that they believed rates would reach a range of at least 1.75% to 2% by the end of the year, with median forecasts coming in at around 1.9%. The median forecast for rates by the end of next year was around 2.8%.
“The Fed sent a strong signal to the market that it has the commitment and willpower to calm inflationary pressures,” said Gary Pollack, head of fixed income trading at Deutsche Bank’s private wealth management unit.
He added that investors already believed that the central bank might raise interest rates at each of its remaining meetings this year. But they were also betting that the Fed itself would signal more caution in its forecasts on Wednesday, which caused short-term bond prices to drop and yields higher when the forecast was released.
By the end of the session, the yield on the two-year major Treasury was flat at 1.956%, according to Tradeweb, up from 1.855% on Tuesday. The yield on the 10-year bond settled at 2.185%, the highest level since May 2019, but just a modest increase from 2.160% on Tuesday and almost unchanged from what it was before the Fed statement. The yield on the 30-year bond fell to 2.456% from 2.503% on Tuesday.
Analysts said Wall Street’s reaction was in some ways identical to recent trends, with investors ready to adjust interest rate expectations for 2022, but became less resilient after that point.
For 2023 and 2024, “investors are really suspicious,” said Priya Misra, head of global price strategy at TD Securities in New York. “It’s far from it,” she added. “Things can change. Inflation will probably come down by then,” especially given what the Fed is likely to do this year, both in terms of raising interest rates and reducing its bond holdings.
Investors and economists pay close attention to treasury yields because they put a lower bound on borrowing costs throughout the economy and are important inputs into the financial models that investors use to value stocks and other assets.
Strongly influenced by investors’ expectations of the short-term rates set by the Fed, changes in yields can have a direct impact on the economy before the central bank actually changes the rates that it directly controls. Already this year, there were signs of a slowdown in housing demand thanks to higher mortgage rates, which are closely linked to the 10-year Treasury yield.
Many investors accept slightly slower economic growth as long as the US can avoid a recession and corporate profits can continue to grow. US stocks have usually done well when the Fed started raising interest rates, in large part because the central bank took these steps when the economy was in a strong position.
Investors are more nervous than usual this year, with the S&P 500 down 8.6% for the year, because inflation is higher than it has been in decades. One risk is that the Fed may be willing to risk a recession, or mistakenly cause a recession, as it tries to tame inflation.
This year it was already Tough for Bond Investors. When inflation began to accelerate last year, investors believed for months that it could calm down on its own, allowing the Federal Reserve to keep short-term interest rates near zero. However, those views have changed quickly this year in large part due to a shift in tone from Fed officials, including Chairman Jerome Powell, who has begun expressing more concern about inflation and eagerness to start raising interest rates.
Lately, though, investors have become more skeptical that the invasion could curb interest rates. Some have argued that the high commodity prices stimulated by the invasion may only increase inflation, leading to increased inflation. Pressure on the Federal Reserve to tighten policy. Meanwhile, energy prices have already pulled back from recent highs, spurred in part by hopes of a negotiated settlement between Russia and Ukraine. This eased the anxiety of those who believed that higher prices could have the opposite effect: slowing economic growth and making it difficult for the Federal Reserve to raise interest rates.
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Regardless of the Fed’s actions on Wednesday, monetary policies – and therefore bond yields – will still be determined largely by the state of the economy.
On that front, new data Wednesday morning showed that Retail sales soar seasonally adjusted 0.3% in February, less than analysts’ expectations for a 0.4% increase. At the same time, the increase in sales for January was revised up to 4.9% from 3.8%.
Treasury yields were little changed after the report was released. In a note to clients, Ian Lyngen, head of US price strategy at BMO Capital Markets, wrote that the data showed a “disturbing trajectory” but that upward revisions to January sales “removed the advantage of the disappointing February numbers.”
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