The Fed is watching MORE than rates The Fed is watching MORE than rates\images\insights\article\security-cameras-small.jpg April 7 2021 March 18 2021

The Fed is watching MORE than rates

And broader markets are not sounding alarms.

Published March 18 2021
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The Fed increasingly has focused on “financial conditions” over the last decade or so and is heavily focused on them now. That means policymakers are watching stock prices, credit spreads and capital markets functioning—factors that go well beyond the level of U.S. Treasury yields. For all the attention they are receiving, the rapid rise in longer Treasury yields since the start of the year has neither caused a steep erosion in broader financial markets nor impaired the functioning of bond, stock or money markets.

So, given that the Fed does not focus on just “one price”—like the level of the 10-year Treasury as Chair Powell again made clear this week—FOMC members seem comfortable watching how much rates reprice higher and how stocks, credit spreads and other indicators of capital market access and functioning respond. This wait-and-see approach has opened the door to higher yields as a growing number of investors expect faster GDP growth and more inflation as vaccinations proceed, the Fed holds rates at zero for the next couple years and the Biden administration pursues rapid fiscal expansion. 

Many in the markets had expected the Fed to act by now to slow or counter the move higher in U.S. yields. But Powell signaled policymakers are willing to remain hands-off for now. Simply reinforcing expectations that the Fed’s target rates will remain near zero for some time, as Powell has done, may dampen the rise in short U.S. Treasury rates but not long-term ones, causing the yield curve to steepen further. Should broader financial conditions erode notably, the Fed may reconsider, and could increase or alter the maturity mix of their bond purchases. 

The bottom line: the sell-off in U.S. Treasuries appears likely to continue unless or until financial conditions erode or other developments lift investor demand. What might those “other developments” be? Higher U.S. yields may attract more foreign and domestic investors. The emergence of new highly contagious coronavirus strains may inhibit growth and weigh on investor sentiment. Higher corporate and personal income taxes in the Biden infrastructure plan that’s still under formulation could offer some fiscal counterweight to the rapid spending and debt issuance already underway. For now, Federated Hermes fixed-income portfolios remain short duration and positioned for a possible test of 2% on the 10-year Treasury yield.

Tags Interest Rates . Fixed Income . Markets/Economy .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

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