The Federal Reserve has caused some panic in the Treasury market. That is the most accurate description that can explain what has happened to long-term Treasury yields since the FOMC decision on June 19.
The panic, which has everything to do with credibility rather than economic fundamentals, suggests market participants have not been willingly holding Treasuries for the past several months. Instead, investments in Treasuries were made because bond holders assumed there would always be a buyer. Now that the market assumes the Fed will be stepping down from that role and tapering quantitative easing, the slack in demand means there may be no ceiling to the uptrend in interest rates.
That brings us to the issue of credibility. Maintaining credibility is the most important job of a central bank. Having credibility allows the central bank to judge policy responses simply by speaking about potential changes in monetary policy and well before they are actually implemented.
Yet, as the Fed found out last week, credibility is a double-edged sword.
Even though the Fed may have thought it was just reiterating what investors already knew -- that quantitative easing would taper off when the economy recovers -- the market reaction shows that the market had not actually priced in the idea that tapering would happen in the near future.
Slow Growth, but Fast Jump in Rates
Since the middle of April, a number of Fed officials have talked about the potential for tapering as the economy strengthens. Stronger-than-expected employment data for April and May increased the probability that tapering would occur sooner than later. However, it was not until Fed Chairman Bernanke explained that tapering could begin as early as this year, and possibly end by the middle of 2014, that Treasury yields blew out. The 10-year Treasury yield reached 2.66% on Monday, which was its highest level since 2011.
According to The Economist, Federal Reserve models show that tapering would raise long-term rates by five to ten basis points. That is a clear underestimation. Since the May 1 FOMC meeting, real expected yields have jumped by nearly 100 bps at the long end of the curve.
The increase in long-term bonds would not be problematic if it was accompanied by or caused by stronger growth. That, however, is not what the Fed is predicting. In fact, the Fed downgraded its GDP forecasts for 2013 in its latest projections.
The underlying inflation data agrees with the Fed's assessment about economic growth. That is, it reflects an environment of slower, not faster, growth.
Inflation Expectations Deflated
Inflation can be looked at as a proxy for future income growth. Producers pass through higher commodity prices to consumers as long as they believe consumers will be able to afford these prices at a later date.
Using this definition, the economy does not look to be in healthy shape.
Consumer prices, as measured by the CPI, PCE, or the Cleveland Fed's Mean and Trimmed indices, have been falling steadily for the past year. Meanwhile, during the same time period, the CRB Raw Industrials Spot Index has strengthened.
Producers are facing tightening profit margins and are unable to expand them without significant loss of demand from soft income growth. In a nutshell, the data suggest that producers believe the economy will not strengthen enough in the near future to pass through higher prices.
Most astonishingly, core PCE prices, which the Fed monitors for its inflation mandate, increased only 1.05% y/y in April. That was the smallest annual increase since data started being collected in 1959 and nearly 150 basis points less than the Fed's stated goal when QE3 was announced.
These trends have not been lost on market participants.
Inflation expectations based off of TIPS rates have fallen significantly since May 1.
The 5-year, 5-year forward, which measures annual CPI growth for five years, five years from today, stands at 2.33%. That means the market believes soft economic growth will curtail inflation and keep price growth below the Fed's CPI target of 2.5% in the long-run.
Muddled Approach, Rising Risk
So we have an economy that is showing sluggish growth at best, a Federal Reserve that is forecasting softer growth this year, market participants who agree with that assessment as they drive down inflation expectations, and an evolving FOMC policy stance that is giving investors added reason to think the Fed's buying power is more likely to decrease sooner rather than later.
In essence, the Fed has created a topsy-turvy environment in which investors are expected to deal with higher interest rates and at the same time assume weak growth.
It is no wonder that St. Louis Fed President Bullard dissented at the June 19 FOMC meeting and warned in a strongly worded follow-up statement that tying policy to calendar dates instead of economic data is bad policy.
Chairman Bernanke should be rewarded for increasing transparency at the Federal Reserve, but right now we are seeing a rash of different policy opinions from Federal Reserve presidents and a Fed chairman who is laboring to maintain an orderly consensus viewpoint. This all leads to a muddled policy initiative driven by the credibility that policy follows tightly from all of these contrasting statements.
Interest rates do not need to rise forever, and the Fed could put a stop to the recent move. One direct and transparent way it could do that would be for the Fed chairman to flat out say the market has overreacted to the recent discussion of tapering and to provide the reminder once again that policy decisions will be data dependent and not calendar dependent.
If the Fed is unable to calm prevailing expectations, the risk increases that rising interest rates will be an economic growth killer.