Fed Walking A Very Tightrope

The FOMC concludes its two-day meeting later today. Rates on the short end of the yield curve are behaving but the long end is perking up. This is taking place at a time when foreigners are aggressively selling treasury notes and bonds. The Fed, in contrast, is a buyer of these securities, but markets want more, hoping for some kind of an operation twist.

The FOMC concludes its two-day meeting later today. It is the year’s second, and six more remain. Not much is expected on the rates front. The fed funds rate is already zero-bound. Markets would be more interested in hearing about what the statement, and Chair Jerome Powell later in the press conference, says about the inflation outlook and the recent backup in 10- and 30-year T-rates.

Treasury Secretary Janet Yellen last week brushed off inflation fears owing to the $1.9-trillion stimulus package that just became law, adding they have tools to address it. The conventional tool – the benchmark rate – already lies in a range of zero to 25 basis points (Chart 1). It cannot go any lower, unless rates go negative, the benefit of which is debatable.

Quantitative easing (QE) is the unconventional tool that the Fed has aggressively pursued since pretty much the great financial crisis. In August of 2019, its assets bottomed at $3.76 trillion, before going parabolic last March. Last Wednesday, they had ballooned to $7.58 trillion.

One can argue that the aggressive expansion of its balance sheet is exactly what is causing all the dislocation in the system. Unwinding of this – if ever – is bound to leave behind a trail of cries and tears. Right here and now, markets – both bond and equity – are not too bothered by these prospects.

Of late, the long end of the treasury yield curve is rallying. Inflation fears have grown, given growth prospects this year and the amount of stimulus money – both monetary and fiscal – sloshing around.

Last March, the 10-year treasury yield bottomed at 0.4 percent. Last Friday, these notes were yielding 1.64 percent. Rates have pretty much gone sideways just north of 1.6 percent the past three weeks, with Tuesday closing at 1.62 percent (Chart 2).

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