The U.S. bond market will be watching for ongoing reassurance from the Federal Reserve that it will maintain its bond purchases for the foreseeable future - or risk a disorderly rise in yields.
Yields spiked to 10-month highs this month after Democrats won effective control of the U.S. Senate, increasing bets on higher fiscal spending, rising inflation and possibly a faster economic recovery.
Speculation also grew that the U.S. central bank would be quicker to pull back its support for the economy, possibly even tapering bond purchases this year.
But the yield increase, with 10-year yields jumping more than 20 basis points in a week to 1.187%, prompted Fed officials to push back - and yields have retraced to 1.023%.
The Fed on Wednesday pledged to keep its key overnight interest rate near zero and leave its bond purchase program unchanged until there is a full rebound from the pandemic-triggered recession.
“Worry about the Fed tapering its stimulus is premature right now, as the slow COVID-19 vaccine rollout will likely delay any kind of Fed stimulus withdrawal until well into 2022,” said Danielle DiMartino Booth, chief executive officer and chief strategist at Quill Intelligence in Dallas.
However, “the bond market remains unconvinced of the Fed’s commitment to low rates and stimulus, given the volatility in Treasury yields over the past month,” Booth said.
Fed Chair Jerome Powell stressed on Wednesday that the central bank will rely on guidance and communicate well in advance of what will be a gradual taper when the economy is ready.
Powell’s ability to stop the market from front-running potential Fed moves will be key for whether future yield increases become disruptive, analysts said.
If investors begin pricing for less Fed support before the economy shows improvement and the Fed indicates it is ready, yield increases could dent any recovery and hurt riskier assets, including stocks.
“It’s critical in the context of the recovery that you expect in 2021 for the Fed to stay very credible in their dovish messaging,” said Bruno Braizinha, an interest rate strategist at Bank of America in New York.
Braizinha expects yields to increase gradually, with momentum expected to pick up in the second half of the year. “But for this movement to be orderly, it’s necessary that the Fed keeps a concerted message around the removal of accommodation,” he said.
The biggest risk of a “tantrum,” which could be a 50-basis point increase in 10-year yields in two months, will be near the end of the second quarter or the beginning of the third quarter, when the economy is expected to show improvement, Bank of America said.
“Even if the Fed stays dovish it’s going to be difficult to control the message at that point,” Braizinha said. If there is a sharp increase to the 1.5% to 1.75% area without solid economic improvement, that “is going to impact the risky asset outlook.”
Another key component regarding the impact of higher yields will be whether they are driven by higher inflation expectations.
Yield increases prompted by the Fed paring bond purchases could hurt stocks, but “if yields go up because the economy is on fire and inflation expectations are moving up, then that’s OK for stocks,” said Peter Berezin, chief global strategist at BCA Research in Montreal.
Ten-year real yields, Treasury yields that adjust for expected inflation, are trading at minus 1.04% after inflation expectations this month jumped to 2.17%, the highest since May 2018.
One possible beneficiary of rising bond yields could also be bank stocks, Berezin said. “Not only are they cheap, they also are a hedge against a bigger-than-expected rise in yields.”
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