Why Doesn't The Bond Market Trust The Fed?

George Yacik - INO.com Contributor - Fed & Interest Rates

The minutes of the Federal Reserve’s January 31-February 1 meeting released last week said we can expect another interest rate increase “fairly soon,” which many people think means at the March 14-15 meeting, just two weeks away. But the bond market doesn’t seem to be buying it. Why not?

According to the minutes, “many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the committee’s maximum-employment and inflation objectives increased.”

At her Congressional testimony a week earlier, Fed Chair Janet Yellen was even more hawkish, warning that “waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.” That doesn’t sound like someone who’s willing to wait until May, the Fed’s next monetary policy meeting after March (there’s no meeting in April).

Yet the bond market’s reaction last week was to send interest rates lower, not higher, as might have been expected. Indeed, the yield on the benchmark 10-year Treasury note ended last week at 2.31%, its lowest closing level since the end of November, down more than 10 basis points for the week and off nearly 30 bps since the recent peak of 2.59% in mid-December.

That would surely indicate that the consensus belief is that nothing is going to happen next month, meaning the next chance for a rate hike isn’t until May.

Why is the market so skeptical? After all, recent inflation and employment figures more than justify monetary tightening, as the Fed minutes suggest.

Both consumer and producer price indexes rose 0.6% in January, their biggest monthly gains in several years, although the numbers were skewed a bit by higher gasoline prices. Looking at the January employment report, the 227,000 increase in nonfarm payrolls was much higher than expected. The unemployment rate (which always needs to be taken with a grain of salt) did inch up to 4.8%, but that was largely due to a rise in the labor-force participation rate to 62.9% from 62.7%, indicating that more people were motivated to look for work. While I would hardly characterize this as evidence of a “tight” labor market, as the Fed has, it’s still an improvement.

The fact is, the economy is in fact getting stronger, as other economic indicators show.

But there is still ample reason for the market to be skeptical. If the Fed holds true to its behavior over the past several years, it should be in no rush to raise rates.

During President Obama’s eight years in office, the Fed raised rates exactly one time, back in December 2015 (not counting the most recent rate increase in December 2016, after Donald Trump was elected and Obama became a lame duck). Under Obama, the Fed positively bent over backward not to tighten monetary policy, even when reasonable people could make a strong argument that the economy was buoyant enough to handle it. Yet the Fed always found an excuse, either here or abroad, not to tighten.

Will the Fed grant the same courtesy to President Trump? After all, he’s been president for a month (although it certainly seems like a lot longer!). While Trump’s comments about expanding the economy through tax cuts, deregulation and government infrastructure projects sound inflationary, there’s no guarantee that any of those things will materialize, and if they do happen they will work. To be consistent, the Fed should be willing to wait and see what happens. Perhaps that’s what the bond market believes.

But that doesn’t mean it’s a good thing. As I’ve said over and over the past several years, allowing short-term interest rates to remain largely near zero for so long has created enormous distortions in asset prices and the capital markets, including allowing the federal government to continue to borrow massive amounts of money as if there were no costs associated with it. At some point the piper has to be paid, or the whole thing is going to blow up.

Unfortunately, if it does raise rates now, the Fed will call into serious question its supposed “independence” and “nonpolitical” nature. Raising rates twice in just the five months since Trump’s election, after doing practically nothing for eight years under Obama, will leave a lot of people skeptical that the Fed’s decisions aren’t politically motivated. Maybe that explains why the bond market doesn’t trust the Fed.

But that doesn’t mean you should lower your guard. I’d say the odds are a lot higher for a March rate hike than the market thinks. As someone once said, “Beware the Ides of March.”

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.