It looks as if bond yields are going higher.
On the last day of 2021, I went out on a limb and suggested that the yield on the 10-year U.S. Treasury note would reach 2.50 percent by the end of 2022.
And, today, January 10, 2022, the yield on the 10-year U.S. Treasury note cruised above 1.80 percent.
This yield had not been at this level since early January 2020, just before the news about the spread of Covid-19 to the United States became well known.
For the past two years, this yield has remained at very low levels and has only really started to rise when the Federal Reserve began to get serious about the tapering of its monthly purchases from the $120.0 billion per month amount it has been at.
The Federal Reserve also began talking about raising its policy rate of interest, the Federal Funds rate, as soon as the tapering of purchases ended.
The Federal Reserve has maintained the effective Federal Funds rate at 0.08 percent since September 1, 2021, but has indicated that it might raise this rate three times in 2022.
Some analysts are now saying that the Fed will raise its policy rate as many as four times this year.
The latest projections of the Federal Funds rate from the Fed, released after the December meeting of the Federal Open Market Committee, show that Federal Reserve officials are forecasting that the Federal Funds rate would be at 0.90 percent at the end of 2022.
This would be consistent with the Federal Reserve moving its “target range” for the Federal Funds rate three times in 2022, with the range ending up the year at 0.75 percent to 1.00 percent.
Federal Reserve officials do not see the Federal Funds rate getting up around 2.5 percent until “the longer run,” which, in the Fed’s scheme of things, means after 2024.
This does not, however, exclude the Funds rate going about this 2.5 percent since the forecasts are just for end-of-period numbers.
The point is that Federal Reserve officials see interest rates rising in the near future. However, there is no indication of how this rise in the Federal Funds rate will be translated into longer-term yields.
If the yield curve remains positive over this time period, it is not unreasonable to think that the yield on the 10-year U.S. Treasury note might reach 2.50 percent by the end of 2022.
Can The Fed Do It?
That is, can the Fed move the Federal Funds rate along the path that it has pictured in its projections?
Sam Goldfarb, writing in the Wall Street Journal, raises an important point:
Mr. Goldfarb writes that in the previous period of economic expansion,
when the central bank did raise rates that high (2.5 percent) only to quickly retreat when growth started to falter and stocks fell sharply.
This concern is a real one because investors are now so sensitive to what the Federal Reserve is doing and how important the Fed is for sustaining rising stock prices.
Mr. Goldfarb implies that if the Fed creates any picture of real monetary restraint, investors will quickly move out of the market.
And, if the Federal Reserve goes even further and begins to allow its portfolio of securities to decline, even just due to bonds maturing, investors will really get scared and move quickly out of the stock market.
Some analysts are beginning to ask questions about how the Fed might actually oversee a reduction in the size of its securities portfolio. These analysts know that such a move may be needed to fight the inflationary pressures that are now being felt throughout the economy, but that any move to reduce the size of the Fed’s portfolio might really scare investors, leading to an even greater sell-off.
Federal Reserve officials are very sensitive to these concerns.
But, Back To The Bond Market
The trend in the bond market seems to be upwards. And, the trajectory seems to be one that will be sustained.
But, it is a trajectory that will be managed.
On the one hand, the Federal Reserve is going to raise its policy rate of interest.
On the other hand, the Federal Reserve is very concerned about the response of investors, as mentioned above.
Thus, the picture is that the Fed will raise interest rates but at a relatively slow rate. The Fed needs to show that it is fighting inflation, but the Fed also needs to show that it is not going to “shut down” the economy.
Mr. Goldfarb writes:
Investors and analysts point to one simple reason why yields could keep climbing this year: Despite the recent selloff, bond yields still reflect investors’ expectations that the Fed won’t raise rates as high as central-bank officials have indicated they think likely.”
“Interest-rate derivatives suggested Friday that investors think short-term rates will reach around 1.7 percent in four years and then hang around close to that level for the rest of the decade.”
In other words, investors think that Fed Chairman Jerome Powell will be very careful in attempting to manage the transition from excessive monetary ease to a monetary policy that fights against a rising inflation.
Mr. Powell has always exhibited a desire to err on the side of monetary ease, not wanting to set off any disruptive eruption of the stock market or the economy. When the pandemic hit, he went all-out to make sure that the Fed did not create an environment that could be considered restrictive in any way.
I can’t conceive of Mr. Powell acting differently going forward. Mr. Powell wants to be very, very careful to keep the economy going.
In order to achieve this, the Federal Reserve will not raise its policy rate of interest too rapidly and it will be very slow to reduce the size of its securities portfolio.
As a consequence, the Fed Funds rate will rise slowly and the markets will take the longer-term yields up a little bit faster.
I still think that a yield for the 10-year U.S. Treasury note of 2.5 percent is not too high to be reached by the end of this year. And, I think I am erring on the low side in this forecast.