Treasury yields rose to their highest levels since July as a risk-on tone took hold following Wednesday’s Federal Reserve meeting that set the stage for a reduction in the policies put in place during the pandemic.
Although the Fed kept its $120bn monthly purchases of Treasuries and mortgage securities intact, chairman Jerome Powell said during a press conference that the committee is essentially one “good” jobs report away from announcing a reduction in the asset purchases and is expected to make the move by its next meeting in November.
The possible reduction in support suggests that the cautious Federal Reserve committee is seeing improvements in the economy toward full employment and its inflation target of more than 2%. While the reduction of monetary support is generally bad for markets, it does signal that the Fed believes the economy is growing strong enough without it.
Institutional investors flee Treasuries
That economic prognosis has institutional investors taking money out of Treasuries, which caused the 10-year benchmark rate to close 9 basis points higher at 1.41%, its highest level since closing at 1.42% in mid-July. At the short end of the benchmark curve, three-year Treasuries closed 5bp wider at 0.53% – its highest mark in more than a year.
Some of those funds seem to be going back into the higher returns in the equity market where the Dow Jones Industrial Average is trading up 1.5% on the day while the S&P 500 is up 1.21%.
The federal funds rate remains low
The Federal Reserve kept interest rates near zero, but the expected November tapering of asset purchases is viewed as a first step toward eventually raising rates.
Six members indicated they would raise rates by 0.25% in 2022, up from five members at the June meeting. Three members signalled that a 0.5% increase in the rate is warranted next year, up from two over the summer.
The expectation of higher rates in the future is causing Treasury yields to rise, which cuts into the returns for bond investors and exchange-traded funds that are inversely correlated to moves in the Treasury market.
While tapering is a first step, Powell noted that the economy is still “well away” from satisfying the test for lifting the federal funds rate above its current 0.00–0.25% range.
“The conditions for liftoff have decisively not been met yet, and Fed officials are evenly split between starting to hike in 2022 vs. 2023,” Bank of America analysts wrote in a report this week reviewed by Capital.com. “However, what is clear is that at the end of the forecast horizon in 2024, rates will still be below the long-run rate forecast, suggesting that policy will be supportive.”
The Federal Reserve largely looked back at the July to September time frame and did little to acknowledge that Covid-19 cases in the US are declining in recent weeks, BofA credit strategist Hans Mikkelsen wrote in a note this week viewed by Capital.com.
For example, Covid-19 hospitalizations reached a peak in late August at 104,000 when cases were increasing by 43% week-over-week, the report noted. But since then hospitalizations have declined by 11% to 88,000.
“Delta peaked more than a month ago and is now declining rapidly, which we think the Fed has yet to appreciate,” Mikkelsen said. “Hence we look for the Fed to continue to become increasingly hawkish, which can't be positive for investment-grade credit spreads.”