The recent spike in nominal yields has created a genuine sense of unease in the financial markets as investors rush to reassess if risk has been priced appropriately. The U.S. Federal Reserve’s (Fed’s) meeting on March 17 has taken on additional significance, as markets turn to the central bank once again for clues on what it might do next. Ultimately, we think there are three critical questions that the Fed needs to address.
1 Is the rise in yields merely a reflection of a better economic outlook?
Our view: Only partly
2 What would trigger a reaction from the Fed?
Our view: Rising nominal yields alone—what we’ve seen so far—aren’t enough of a trigger; substantially more would need to transpire before the Fed will act
3 If the Fed is triggered, what course of action will it take?
Our view: Verbal intervention and forward guidance in the first instance, long before yield curve control (YCC)¹
Understandably, our view will evolve as additional economic data becomes available and interest rates move. At this juncture, we believe that U.S. interest rates had initially moved up for the right reasons—that is, on the back of stronger growth expectations; however, subsequent moves on the 10 year above 1.3% have been more problematic. Crucially, as of this writing, we do not expect the central bank to initiate concrete intervention.
Herein lies a key issue: The rise in rates driven by nonreflation/growth reasons combined with what can be perceived as a feeble Fed response is likely to be the most problematic outcome for risk assets in general and most consistent with a rise in real rates.
Fed options and the likely market response
Market interpretation/likely response
|Recent interest-rate movement is a problem—rates are rising for the wrong reasons||Recent interest-rate movement isn’t a problem—it merely reflects a stronger growth outlook|
Fed responds with concrete intervention (Operation Twist²/YCC)
|Fed doesn’t respond, or is perceived to have responded poorly||
What has driven U.S. interest rates higher in recent weeks?
We’ve identified four main reasons why yields have pushed higher: economic optimism, expectations of an earlier Fed exit, concerns related to the looming expiration of the supplementary leverage ratio (SLR) exemption, and convexity hedging related to mortgage bonds. Note that not all of them are related to the expected reopening of the economy or improving growth outlook. If they were, we’d be far more sanguine about the rise in rates.
1 Economic optimism
This is sparked by positive news flow relating to improved vaccine distribution and confirmation that the federal government will indeed provide fiscal support to the economy.
This is likely to have fueled the rise in 10-year U.S. interest rates to 1.3%, led by Treasury Inflation-Protected Securities (TIPS) breakevens.
2 An earlier Fed exit
In our view, much of the rise in the 10-year U.S. interest rate above the 1.3% level has been driven by higher real yields and not breakevens, which suggests the move has less to do with the market pricing in more inflation and is more of a reflection of investor expectation that the Fed will normalize rates sooner, even if inflation didn’t rise materially above 2%.
A better-than-expected February non-farm payrolls report also reinforced the market’s belief that the Fed might normalize rates sooner rather than later. In addition, there's a general sense among investors that Fed Chair Jerome Powell didn’t seem too concerned about the impact that rising interest rates had on the equities market when he spoke at a webinar on March 4.³
We believe these developments are behind the recent move in the 10-year U.S. interest rate from 1.3% to 1.5%, led by real yields.
3 Threat of the SLR exemption expiring
The SLR exemption, which temporarily allows banks to hold less capital relative to their liabilities, is set to expire on March 31. If this were to happen, banks will have to hold more capital against their holdings of U.S. Treasuries. Put differently, the looming expiration of SLR exemption is disincentivizing banks from buying U.S. Treasuries and simultaneously encouraging speculators to take short positions in these instruments. Crucially, Fed Chair Powell was noncommittal about the extension at the recent congressional hearing,⁴ and several Democrats have asked for the SLR to be cut,⁵ lending credence to concerns that the exemption won't be extended.
These developments are likely to have exacerbated the move in the 10-year U.S. interest rate from 1.5% to 1.6%.
4 Convexity hedging
One of the key distinguishing characteristics of mortgage bonds, which are often held by large investors such as asset managers and banks, is negative convexity. In other words, when interest rates rise, the duration of these securities also goes up.
Since investors tend to have a preference for stable returns and constant duration, those with exposure to mortgage securities typically sell U.S. Treasury durations when rates go up (and vice versa) as a way to manage this risk.
Understandably, the duration for mortgage bonds has risen sharply this year, which could have exacerbated the wave of U.S. Treasury selling, pushing rates higher.
It's likely that convexity hedging might have exacerbated the rise in the 10-year U.S. interest rate from 1.5% to 1.6%.
"In view of the intense market reaction we’ve witnessed in recent weeks, it makes sense for the Fed to communicate clearly and leave little room for miscommunication—failure to do so could be costly."
What could prompt the Fed to act?
Although we're seeing signs of trouble brewing in the markets, we don’t believe enough has transpired to spur the Fed into action, particularly in light of recent comments by its officials. However, it’s entirely possible that events could unfold in such a manner that could convince the Fed to change its mind before the March 17 meeting, or even in the next few months. In our view, the Fed is more likely to respond to the bigger economic picture and act in a holistic manner rather than react to a specific trigger.
Factors to monitor
|Potential trigger||Has it occurred?||What to monitor|
|The front end of the U.S. yield curve begins to lift||It’s beginning to happen||U.S. front-end rates currently imply that the first rate hike could take place in Q4 2022 and that interest rates could rise by 60 basis points by Q1 2023. That’s inconsistent with the Fed’s messaging relating to its recently adopted average inflation-targeting mechanism, its focus on employment, and its economic projections, which indicate that rates will only rise in 2024⁶|
|Financial conditions materially worsen||No||
|Inflation expectations materially soften (breakevens at less than 2.0% for an extended period)||It’s beginning to happen||While break-even inflation rates have softened, they still remain consistent with a 2.0% to 2.5% inflation outlook. As such, the Fed doesn’t need to push inflation expectations higher. Note: Fed buying may be a distorting signal from breakevens; for instance, the Fed already owns nearly 20% of the TIPS markets⁷|
|Concern the real economy could worsen through indicators such as mortgage rates, consumer spending, and employment||It’s beginning to happen||Primary mortgage rates have hit 3%—still low by historical standards—which may already be hampering mortgage applications and new home sales; however, there’s limited evidence that the economy is being unreasonably hampered, for now (this typically becomes more observable after a lag). February’s non-farm payrolls⁷ point to growing strength in the jobs market. In our view, a material spike in both mortgage rates and weekly jobless claims, combined with other triggers, could encourage intervention|
|Smooth functioning of the financial markets||It’s beginning to happen||We’re seeing some initial but nonmaterial evidence of a deterioration in liquidity in the U.S. Treasury market|
We’re generally expecting that the Fed will lean against near-term interest-rate hikes currently priced into 2022 and 2023 through strengthened forward guidance and intermeeting communication. The central bank could emphasize that rate hikes aren’t on the table while it remains engaged in quantitative easing (QE) and could turn to what we call calendar-based guidance as a way to pin down the front end of the U.S. yield curve.
In addition, the Fed could introduce some form of tinkering at its March 17 meeting, which could include an extension of the SLR exemption (to encourage banks to hold U.S. Treasuries) and, perhaps, introduce a slight increase to the interest it pays to banks on overnight reserves, which will be a technical adjustment in nature. In view of the intense market reaction we’ve witnessed in recent weeks, it makes sense for the Fed to communicate clearly and leave little room for miscommunication—failure to do so could be costly.
1 Yield curve control refers to a monetary policy tool where a central bank explicitly sets a target for a longer-term interest rate and pledges to keep the rate from rising above its target. 2 Operation Twist is one of many policy tools that central banks can adopt when implementing quantitative easing. The policy is aimed at stimulating economic growth by lowering long-term interest rates, which can be achieved when a central bank finances its purchase of long-term bonds (through its bond purchasing program) with proceeds from the sale of its near-term bond holdings. 3 “Stock Market Momentum Comeuppance Gets No Sympathy From the Fed,” Bloomberg, March 4, 2021. 4 “A $50 Billion Unwind Fueled Treasuries’ Rout. It Has Room to Run,” Bloomberg, March 5, 2021. 5 “Democratic senators call for tougher capital requirements for US banks,” Financial Times, March 2, 2021. 6 federalreserve.gov, as of March 8, 2021. 7 Macrobond, Bloomberg, as of March 5, 2021.
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