The verdict is in. The February FOMC statement tilted a little bit hawkish compared to the January statement. The Fed grudgingly allowed that growth was picking up:
The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate....but left the door open for further easing because they did not see inflation to be a threat:
The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.There was no mention of any discussion about other measures, such as sterilized QE. In effect, the Fed is in a wait and see mode, but signaled that it is prepared to stimulate should signs of weakness appear. However, it did also indicate that tightening is not around the corner.
Bond yields go on a tear
So what was the market reaction? In the wake of the FOMC announcement, Treasury yields spiked. Not only did 10-year yields rally through a critical technical resistance level, it breached a downtrend that began in April 2011.
In effect, the bond market is saying that an economic recovery appears to be self sustaining. Under these circumstances, bond yields should be rising as faster growth would raise inflationary expectations.
In the wake of the sudden rise in Treasury yields, the blogosphere has been full of stories about how the Chinese have either stopped or lessened their purchase of Treasury securities because of their falling current account surplus and need to import commodities, such as oil (see examples here and here). While that might a plausible longer term explanation, Chinese demand didn't change on a dime on Tuesday after the FOMC meeting. Market expectations did.
Here is the risk for the Bernanke Fed. The Fed has traditionally used the short end of the yield curve to inject or withdraw liquidity from the market. Now the Bernanke has began to use "unconventional" measures to intervene in the long end of the curve. There has been a lot of discussion and hand wringing at the Fed about why housing didn't respond well to these stimulus measures. Indeed, there was discussion about how the next round of QE would be targeted at the MBS market instead of just the Treasury market.
Mortgage rates are benchmarked off Treasury yields. As Treasury yields rise, which they are doing now, mortgage rates should respond. In effect, this backup in Treasury yields has to potential to kill the fragile housing recovery (if there is one) and Bernanke is at risk of losing control of the bond market as an instrument of Fed policy.
If the markets are tightening when the Fed doesn't want to tighten, how will it respond?
In the past, the Federal Reserve has used interviews and leaks after significant announcements to "clarify" its statements. Watch for further statements in the days to come to see the Fed's reaction to the backup in bond yields. On the other hand, if there is no comment within the next couple of weeks, then I would interpret the silence as a signal that the central bank is comfortable with a rise in bond yields.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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