Talking taper, but not much else
While curtailing bond purchases were discussed, the FOMC today offered little additional insight.
Federal Reserve Chair Jerome Powell today said there is “ground to cover” in the progress of the economic recovery but revealed that policymakers have begun to discuss tapering its bond buying program. A late July Federal Open Market Committee meeting without updates on economic projections or a dot plot offering clues on future moves in the target funds rate hardly is a recipe for drama. A parsing of the statement showed only minor changes in the wording. Yet even the mention of taper talk is noteworthy.
All that said, investors keenly watching this meeting for any clues on the Fed’s thinking arguably got a few. Powell maintained inflation is largely transitory but that the Fed will act if it is more persistent than expected. How it would respond was left unsaid. If it is tapering, no decision has been made on the timing, only that the economy has made progress toward preconditions for tapering asset purchases, and the Fed will continue to assess progress in coming meetings. He remained optimistic on the outlook for the economy but acknowledged the delta virus variant represents a risk but said “there has tended to be less in the way of economic implications with each wave.”
Looking ahead, inflation likely is going to remain a dominant factor in market behavior in the weeks and months ahead. It has surged well above consensus forecasts to multi-decade highs as the economy has rebounded dramatically from the depths of the Covid-19 recession, leaving two questions hovering over the market: how much higher might it go and how much longer might it last? While core consumer prices have risen to near a 30-year high, Powell reiterated the stance he took before Congress earlier this month, that higher inflation will prove temporary and he was still a long way away from raising rates.
Markets appeared to view today’s events as slightly dovish, with longer yields moving little and breakeven inflation rates rising. The likely path of U.S. Treasury bond yields and credit performance is highly dependent on the Fed’s view on inflation, the economy and what the Fed may do next and today didn’t give them much to go on. So, we’re left with a market that arguably has been acting counterintuitively to the fundamentals—even as inflation has accelerated and government debt has soared (and appears headed even higher via an infrastructure bill), longer yields are significantly below their March highs. The 10-year Treasury yield, for example, is down more than 50 basis points since then and the gap between 2- and 10-year yields, which generally widens when higher inflation is expected, has narrowed close to 100 basis points, less than its average for the last couple decades, a period when inflation wasn’t a problem. Frankly, this doesn’t really make sense unless the market thinks the Delta variant may shut the global economy down again or that the Fed will make a policy mistake, acting too soon or too aggressively to quell inflation pressures, thus hurting the economy. Neither are views we share, nor heard today.