Fed's Concern Over Muted Inflation Is Supportive For Short-Term Treasuries

Includes: SHY
by: Sankalp Soni

Short-term Treasury yields have been plummeting over the past several months amid a dovish Fed.

Given that expectations of higher inflation did not materialize, Fed members have become wary of further raising interest rates.

Probabilities of rate hikes over upcoming Fed meetings are diminishing.

Short-term Treasury yields had been climbing up strongly last year amid a hawkish Fed. However, over the past several months, they have been declining amid an increasingly dovish Fed, with the 1-yr yield at around 2.535 and 2-yr yield around 2.512. While certain positive economic data releases recently helped short-term yields climb higher, recent concerns expressed by voting Fed members continue to put downward pressure on yields and, hence, support Treasury prices higher.

2-year Treasury yield

Source: CNBC

Fed members are very concerned about inflation

It has now generally been accepted that Fed members have turned very dovish this year amid slowing economic conditions both domestically and globally. Though the main concerns Fed members have are regarding the astonishing lack of inflation pressures. I have been assessing various Fed members' statements made regarding inflation, and their perspectives exhibit that their concerns go beyond just the condition of muted inflation, as they are becoming increasingly nervous over their ability to forecast inflation effectively.

One of the most prominent voting Fed members, John Williams, is one central banker that has turned from hawkish to dovish this year amid the absence of stronger inflation. Though his concerns do not stop there.

Yahoo Finance reported that:

He expressed frustration with how some inflation readings have misled policymakers on how close they are to the Fed's 2% inflation target, ... acknowledged that inflation readings are "not a perfect measure," adding that inflation expectations in particular are hard to measure.

Various Fed members last year were expecting strong jobs growth and wage growth to add to inflation pressures. Given that this did not materialize, central bankers are now cautious over continuing to raise rates as they worry any future inflation that they are currently anticipating may not materialize either. In fact, Fed member Richard Clarida recently claimed, "models that we consult are not infallible".

Reuters reported that:

Vice Chairman Richard Clarida… said the Fed should discount any models that project a surge of inflation and wait for incoming data to prove it is happening.

Therefore, even if signs start emerging that inflation may begin rising going forward, the Fed is likely to be reluctant to start raising rates again immediately, given that they could end up hurting the economy if higher inflation does not materialize and instead cause the economy to contract by more than intended. This means that the Fed is unlikely to raise the fed funds rate any time soon, which will put downward pressure on yields and support Treasury prices.

Probability of rate hikes is diminished

The Fed's persistent concerns and dovishness have certainly lowered bets among fed funds futures traders that the Fed will hike rates in their upcoming meetings. In fact, according to FedWatch, which reflects probabilities of rate changes in upcoming meetings in correlation to fed funds futures activity, the chances of rate cuts exceed the chances of rate hikes for every single FOMC meeting up till January 2020 (at time of writing). Thus, with a diminishing outlook for future interest rates, short-term Treasury yields are likely to remain suppressed and, hence, support Treasury prices higher.

Bottom Line

Amid a lack of inflation, Fed members are wary of raising rates further, as they are losing confidence in their own abilities to forecast inflation levels. As a result, the Fed is likely to remain dovish for a longer period of time, which will keep short-term Treasury yields down and support Treasury prices higher.

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