The high threshold for further Fed intervention

At the height of the financial panic that rippled across global markets in March 2020, fixed-income investors called on the Federal Reserve to put the Treasury market on a war footing. 

The plea was to institute a policy last used during the second world war in order to quell volatility in the world’s largest government bond market and return it to normal functioning after a brief but alarming period of illiquidity. 

So-called yield curve control, which was taken up by Australia’s central bank last year and has long been used in Japan, involves the Fed setting targets for Treasury yields and buying as many or as few bonds as necessary to maintain those levels. 

Roughly one year on, investors are again speculating what it would take for the US central bank to go to these great lengths — or any others to keep a lid on long-term Treasury yields — on account of the sharp rise in borrowing costs that has accompanied improving sentiment about the booming economic recovery already taking hold this year. 

But the bar for further intervention is extremely high, and the Fed is far more likely to stay on the sidelines with its current policy intact, or even begin hinting at a gradual retreat, rather than wade deeper into unconventional waters.

“The move in markets reflects fundamentals and the Fed is not going to go against fundamentals,” said Thanos Bardas, global co-head of investment grade fixed income at Neuberger Berman.

As economists have upped their growth and inflation forecasts, the Fed’s approach has been repeatedly tested. Losses for long-dated Treasury bonds have mounted, resulting in the worst quarterly performance in more than four decades. Yields, which rise as prices fall, have in turn surged. The benchmark 10-year note now hovers above 1.7 per cent. That compares with about 0.9 per cent in early January. Trading conditions have at times turned turbulent, and once-mundane Treasury auctions have become flashpoints for further selling. 

The gyrations have not yet rattled top officials at the Fed. Chair Jay Powell underscored last week that the moves to date had been “orderly” and a reflection of an economy on the mend. Gregory Daco, chief US economist at Oxford Economics, said those expecting an intervention from the Fed may be “waiting for Godot”.

According to an Oxford Economics gauge that tracks eight indicators including Treasury yields, the spreads of corporate credit over government bonds, volatility and equity prices, financial conditions remain close to their loosest level in almost 20 years.

Daco calculates that financial conditions at these levels have bolstered real gross domestic product growth by roughly 0.6 percentage points in just the first three months of this year, with a further boost coming in the second quarter through the latter half of the year.

A resurgence of volatility that batters risky assets and begins to constrain economic activity would prompt a rethink from the Fed, investors said. 

“If you had the equity market down 15 per cent and you saw credit spreads widen and credit growth set to slow, that would be the constellation of things that would make the Fed say our growth and inflation outlook is worse than we thought and some incrementally easier policy is necessary,” said James Sweeney, chief economist at Credit Suisse.

Signs that rising US borrowing costs are negatively affecting the housing market, which has roared back this year, could also compel the Fed to act. But according to Sweeney, it would take a much more material increase to reach that tipping point.

Rather, what may end up occupying most of the Fed’s time as the economy recovers is how exactly it will go about extracting itself from a market in which it has become so embedded.

Powell said in March that the economy had not yet seen the “substantial further progress” necessary for the central bank to begin thinking about pulling back its support and tapering its $120bn-per-month bond-buying programme. But investors believe that the swift pace of the recovery expected later this year — which is likely to be hastened if the Biden administration’s $2tn infrastructure plan is passed — could soon challenge this view.

Taper talk could begin as early as this summer, according to Bardas, while Sweeney reckons the Fed will hold off until its September meeting. Pimco, meanwhile, sees the Fed initiating a “gradual taper” late this year or early in 2022.

Barring some unforeseen setback, the odds for less — not more — Fed support look decidedly more favourable.

colby.smith@ft.com