Will Higher Bond Yields Help - Or Hinder - Fed Policymakers?

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Longer-term bond yields have been ticking up, rising about 40 basis points for the 10-year Treasury since the Brexit vote.

Will the rise in long-term bond yields mean the Fed is constrained by market conditions that seem to have tightened?

A broad measure of financial conditions, though, show that markets are still accommodating, when factoring in credit spreads and other metrics.

Some Fed officials are concerned that too-low Treasury yields force investors into riskier asset classes in a search for return, which can create overvalued assets.

As such, some Fed officials may welcome bond yields that actually carry a premium over expected inflation and may return to more "normal" pricing that lessens distortions.

Longer-term bond yields have been ticking up, not just here, but in Europe as well. The 10-year Treasury now yields about 1.79% versus the 1.36% it touched in early July, following the Brexit vote, in data from Bloomberg. As yields move higher, that could dampen mortgage activity and raise corporate bond interest costs if companies issue debt. So, it would seem, at first glance at least, that the market is doing some of the Fed's work for it by tightening policy through market forces rather than by the Fed's decree. If one is of this mindset, it might be seen as a frustrating element to some Fed officials who might want to nudge up short-term rates as part of an official monetary normalization process.

But really, though, the Fed may welcome the move higher in longer term yields. Current financial conditions aren't restrictive; on the contrary, they're quite accommodating, as depicted in the graph below.

(The National Financial Conditions Index (NFCI) is published by the Chicago Fed and measures risk, liquidity and leverage in money markets and debt and equity markets as well as in the traditional and "shadow" banking systems. Positive values of the NFCI indicate financial conditions that are tighter than average, while negative values indicate financial conditions that are looser than average.)

Looking at this graph, you might notice that financial conditions were loose during the 1990s (when the tech bubble was inflating) and again during much of the 2000s (when we had the housing bubble). Fed officials are keen to avert any more financial imbalances that come from keeping rates too low for too long. Here are few recent quotes on the topic:

Stanley Fischer, vice chair of the Federal Reserve, commented on October 17 that a "concern is that low interest rates may also threaten financial stability as some investors reach for yield and compressed net interest margins make it harder for some financial institutions to build up capital buffers." He did not believe there are any current threats to financial stability, but it is an issue the Fed actively monitors.

Eric Rosengren, president of the Boston Fed, noted recently, "So the fact that long rates are so low, and that there are some sectors of the economy that we're starting to see very rapid asset growth - like commercial real estate, is a source of concern as people start moving to try to get higher returns because we've had low rates for a long period of time." He also notes that Treasury yields are unusually low, given inflation expectations.

In that regard, consider the graph below on the 10-year Treasury yield less the expected inflation rate over the next 10 years, known as the "breakeven inflation rate", which is derived from the pricing of TIPS bonds, or Treasury Inflation Protected Securities.

With Treasury bonds not offering a premium over inflation, no wonder why investors are reaching for yield in other (e.g., riskier) asset classes! Of course, the Fed's stated goals are full employment consistent with low but positive inflation (currently a 2% goal). That said, the Fed does pay attention to asset pricing because, as we've seen twice in the past 20 years, asset bubbles complicate the Fed's mission - especially when they burst.

So, to the extent that longer-term Treasury yields would rise to more "normal" levels, i.e., a yield that would be in excess of expected inflation, Fed officials may be less concerned about the possibility of, shall we say, "mispricing" of assets. Eric Rosengren, president of Boston Fed, commented, "If one were concerned about the historically low 10-year Treasury and commercial real estate capitalization rates, perhaps because of potential financial stability concerns, the balance sheet composition could be adjusted to steepen the yield curve".

However it might happen, the Fed might even be relieved to have longer-term bonds yield at least a little bit more. Even though that could be a damper on economic growth, it would take away some of the risk of financial instability. While we might not be at that point now, a look ahead may point to a desire to have more normal rate conditions sooner than later.


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