It's not much of a conspiracy theory as conspiracy theories go, but is this the Fed's hidden agenda?

Wednesday 11th October 2017

  

It's not much of a conspiracy theory as conspiracy theories go, but is this the Fed's hidden agenda ?

ref :- "Is the Fed wary of sub-2 percent Treasury yields ?" , Jamie McGeever of Reuters Markets

Bloomberg are running a piece today ("Central Bankers Fare Better When They Are Tight Lipped")  that highlights the case being made by two economists from the Swiss National Bank (SNB) that increased communication from central bankers has only served to confuse markets, rather than make things clearer for them. You've got to laugh at SNB officials criticizing the practice of "forward guidance" :

"So Mr Lustenburger and Mr Rossi, you're not fans of central bankers pointing investors in a certain direction, then ? Who'd have thought it  ?"

Forgive the sarcasm .... let's just say that officials from the Swiss National Bank might well say that, mightn't they ? After all, it was the SNB that caused one of the great bouts of turmoil in FX market history in 2015 when they abandoned the cap on the Swiss franc against the Euro just days after totally recommitting themselves to it . What's the opposite of "forward guidance" ?

Anyway, we mention it because it's a nice counterpoint to a commentary on Reuters that speculates that the Fed might have been using it's own rather better communication skills to keep 10yr US Treasury yields above 2%.

The general perception is that the Fed's policy of forward guidance with regard to its thinking on short-term rates has been pretty well handled, and largely successful. The Fed does not have an official policy regarding longer-term yields however, unlike their Japanese counterparts who are committed to keep 10yr yields at or near 0%. In fact, targeting a yield for the 10yr Treasury would be outside their constitutional mandate. Nevertheless, the suggestion is that the Fed have repeatedly used their jawboning prowess to lift yields every time they threaten to break down through that 2% barrier.

Official policy or not, it's not difficult to understand why the Fed (and many others) would want to keep longer bond yields higher and at a healthy premium to the inflation rate. They must surely believe that 2% is a very low rate of return given very tight labour markets, and the majority of Fed officials believe that whilst some adjustment to the employment rate / inflation rate equation might be in order in this changing world, that tightness WILL translate into upward inflationary pressures. They might also feel that tightening financial conditions would be helpful in preventing the markets from overheating.

The Fed has also got the flatness of the yield curve to worry about. It has raised short-term rates four times since Dec 2015, is widely expected to hike again this coming December and thinks it probable that there will be three more rises in 2018 ((though the market's not entirely convinced). The yield on the 2yr US Treasury, more responsive to rate hikes than  longer-term securities, is already at a 9yr high (1.51%), whilst the yield on the 10yr stubbornly refuses to move higher (currently at 2.34%). This plainly constitutes a flattening of the yield curve, something central bankers do not like.

They may put forward the view that the predictive powers of a flat or even inverted yield curve are not as strong as they once were, but the fact remains that historically such events often presage economic slowdown or even recession. They're also very damaging to that crucial sector of any economy, the banking industry. A big part of how banks make money is very simply borrowing short-term at low rates from depositors, and lending longer-term at higher rates to borrowers. Flat yield curves abolish that stream of income at a stroke.

So, the reasons why the Fed might been working to lift the 10yr yield every time it gets uncomfortably close to 2% are sound enough, but what's the evidence ?

On Jan 18th this year with the yield down 30 basis points from the preceding month at 2.31, Fed chair Janet Yellen warns that "waiting too long to start moving toward the neutral rate could risk a nasty surprise down the road  --  either too much inflation, financial instability, or both". Four days later , the 10yr yield was back to 2.55%.

In February, the yield slid back once again to 2.31% and no fewer than four Fed officials were wheeled out to suggest that rates might go up again soon. They were duly raised on March 15th but in the meantime the yield had risen to 2.62%.

Between April 18th - 20th, with the yield making a low for the year (at the time) of 2.17%, the Fed's deputy governor Stanley Fischer and 3 other officials made speeches on the need to unwind the Fed's balance sheet, the benefits of raising rates and the dangers of waiting too long. Cue : a rise in the yield back up to 2.39%.

On June 14th, the yield was bottoming out at 2.11%. The Fed raised rates that very day, which wasn't entirely unexpected, but also made a bold statement  about economic and labour market strength, and announced its plans to reverse QE. The yield rose 30 basis points over the next month.

On Sept 8th, the 10yr yield was on its knees at 2.02%, the yield curve was at its flattest for 10 years and a break below 2% seemed more likely than not. Fed heavy-hitter  William Dudley, president of the New York Fed, arrived on the scene that same day to say that the yield curve wasn't too flat, inflation and wage growth were about to rise and time lags in policy meant that the Fed should be prepared to act even with inflation seemingly below target. The yield started on a rally that peaked at 2.40% last Friday.

Coincidence ? Quite possibly ..... but when looked at like that the evidence seems pretty strong, doesn't it ?  Whatever the case, don't expect Fed officials to admit to defending the 2% level for the 10yr, or to targeting any specific band for any longer yield. You might however expect them to start talking yields higher if that 2% level for the 10yr is threatened again, and let's face it, it's still not that far away.