How the Fed Reserve chief interprets the bond rout
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Fed chair Jerome Powell at the Economic Club of New York on Thursday. Photo: Bess Adler/Bloomberg via Getty Images
For our money, the most interesting segment of Federal Reserve chair Jerome Powell's appearance Thursday at the Economic Club of New York was a discussion of just why long-term interest rates have been surging — and bond prices falling — over the last few months.
Why it matters: Powell is an astute bond market observer — besides having hundreds of economists in his employ, he once was the Treasury undersecretary in charge of issuance — whose decisions also shape it.
- By parsing Thursday's answer, you can get hints of how the Fed will and won't react to the rates surge.
State of play: Powell started by offering his view of what isn't driving the rates surge. Investors don't appear to be pricing in higher long-term inflation (as evidenced by the prices of inflation-protected bonds).
- Nor are they betting on near-term tactical Fed moves (as evidenced by relatively small moves in shorter-term Treasuries).
The story appears to be mainly a shift in the "term premium" that bond investors demand for taking on the risk of potentially higher future rates.
- "It's really happening in term premiums, which is the compensation for holding longer-run securities, and not principally a function of the market looking at [near-term rates]," Powell said in his interview with Bloomberg's David Westin.
- There are "many candidate ideas" for why, and "many people feeling their priors have been confirmed by this event," Powell said, which is what counts as a joke from a Fed chair.
What they're saying: "One would be just that markets and analysts are seeing the resilience of the economy to high interest rates, and they're revising their view about the overall strength of the economy," Powell said, "and thinking, longer-term, this may require higher rates."
- Another is that "there may be heightened focus on fiscal deficits."
- Moreover, quantitative tightening — the Fed's gradual runoff of the longer-term securities — "could be part of it."
He also added a more esoteric possibility to the mix. Over the last 18 months, bonds have tended to move in the same direction as stocks — in contrast to the past, when bonds zig as stocks zag.
- "If we are going forward into a world of more supply shocks rather than demand shocks, that could make bonds a less attractive hedge to equities, and therefore you need to be paid more to own bonds," said Powell.
The ultimate question for policy — and for investors and anyone who cares about the economy — is to what degree this diagnosis of the rates situation may trigger a policy pivot from the central bank.
On that front, Powell was relatively measured, emphasizing that the drivers of the rates surge appear to be mostly things outside the Fed's control.
- "One question is, are we seeing longer-run bond increases in rates come through in financial conditions in a persistent way?" he said. "I think the answer so far would be yes, you are."
- "Then the question is … is it just because the market expects us to take further actions to tighten monetary policy? That doesn't seem to be the case. ... [I]t seems the other actors are more prominent."
Between the lines: The Fed doesn't control the long-term growth trajectory of the economy, nor the future path of U.S. budget deficits, nor the correlation between stocks and bonds and resulting demand for Treasuries.
- As such, Powell mainly seems inclined to take the surge in rates as a given — to monitor carefully and take into account when setting policy — but not something to try to forcefully push back against.
- "I think we have to let this play out and watch it," Powell said. "For now, it's clearly a tightening of financial conditions, and we'll be watching."
The bottom line: Don't count on the Fed to use either its words or policy actions to reverse the run-up in long-term rates, unless the evidence starts to mount that it is causing meaningful damage to the real economy.
Go deeper: The whole exchange is here.
