10-year Treasury yield breaks above 2.6% as Fed gets serious about inflation

Apr. 06, 2022 5:44 AM ETBy: Yoel Minkoff, SA News Editor95 Comments

Fed Vice Chair Nominee Lael Brainard Testifies Before Senate Banking Committee

Drew Angerer/Getty Images News

Investors have been hit with an early surprise before the release of Wednesday's FOMC minutes, which was supposed to give some clues about a reduction of the central bank's $9T balance sheet following a quarter-point rate hike in March. The clues are no longer needed. Fed Vice Chair Lael Brainard pre-empted the minutes on Tuesday by saying a "rapid" reduction could happen as soon as May, calling the move "of paramount importance" to bring down inflationary forces, while the Fed is "prepared to take stronger action if indicators show such action is warranted."

Supply and demand: Treasury yields shot up on the news, climbing 14 basis points on Tuesday to settle at 2.55%. Things kept going on Wednesday morning, with the yield breaching the 2.6% level after rising 7 bps to 2.62%. When the Fed (the biggest buyer of Treasuries) reduces its balance sheet, the market is flooded with supply, meaning prices go down and yields go up (the two have an inverse relationship). As in most markets, current yields factor in future conditions, and all of those are now pointing to a faster pace of quantitative tightening.

Besides pulling liquidity from the financial system, another catalyst weighing on the bond market was a fresh sanctions package announced by the EU that proposed a ban on coal imports from Russia. The elevated commodity prices that are likely to ensue will drive inflation even higher, weighing further on the Treasury market (which is strongly linked to inflation). There's also a 78% chance the Fed will raise its key rate by half a percentage point in May - a pace it hasn't used since 2000 - on top of the median estimate of seven rate increases this year.

Go deeper: The developments saw equities lose some of their steam, with stock valuations ballooning over the last decade alongside Fed balance sheets. There are further fears of slowing growth amid inverted yield curves, while Deutsche Bank has even become the first big bank to forecast a U.S. recession that begins in 2023. "We no longer see the Fed achieving a soft landing," wrote economists led by Matthew Luzzetti. "It is now clear that price stability... is likely to only be achieved through a restrictive monetary policy stance that meaningfully dents demand."

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