We have all heard the saying be careful what you wish for, this exact saying may soon be a reality for the federal reserve. Jerome Powell and many other chairman of the fed, have stated that there isn’t any inflation or that inflation is very low and they are still shy of their inflation target. This just isn’t the truth…
Daniel Tenengauzer, the head of markets strategy at Bank of New York Mellon Corp., is warning the fed that if inflation gets hotter than the Fed’s new policy is aiming for, it may trigger large scale bond selling that will ripple throughout other financial markets. That may force the central banks to adopt a tool to cap long-term yields known as yield-curve control, also known as YCC, he says. The most recent reading of consumer prices to be released Wednesday is supposed to show a still tepid pace of inflation, and the Fed’s preferred measure holds well below “2%.â€The U.S. bond market proxies of future inflation this week have accelerated to the fastest pace we have seen since 2014 as traders eye the prospects of more fiscal stimulus and an improving U.S. vaccine rollout. The 30-year Treasury yields declined 2% this week for the first time since February 2020. “A meaningful upside surprise in realized inflation may, therefore, turn out to be a double edged sword,†Tenengauzer wrote in a research paper. “While a 3% year-over-year CPI inflation overshoot in 2021 would be exactly what the Fed needs to claim ‘mission accomplished’, an ensuing duration selling may trigger a broader market reaction.†Time duration risk in the marketplace is near record highs, after years of near zero interest rates and historic debt issuance, has left both bonds and stocks uniquely vulnerable if yields do rise sharply.
The U.S. 10 year breakeven rate, the yield difference between the benchmark Treasury note and its inflation protected counterpart known as TIPS, touched as high as 2.216% Monday. TIPS are tied to consumer prices, which have historically surpassed the fed inflation rate targets- personal consumption expenditure index; by about 40 basis points. So the current breakeven rates still imply the Fed will miss its 2% target on average over the next 10 years. Under a new policy framework adopted in 2020, the Fed wants an average inflation rate of 2% over time, which means it could tolerate a higher one for a sometime. In 2021 the headline CPI will have to be at least 3% for the Fed to consider hiking its policy rate, leaving room for additional duration sell-off, Tenengauzer wrote. January’s measure is projected to show consumer prices climbed last month at a 1.5% annual pace, the fastest since March, according to a Bloomberg survey of economists. After pondering pondering yield-curve control, or yield caps, last year the fed ultimately backed away from the policy. The central bank still continues to buy $80 billion in Treasuries each month as part of its bond buying programs.
“Moreover, before Federal Reserve officials signaled YCC, we think higher bond yields must be painful enough to trigger financial market distress,†Tenengauzer stated.