Economist

Richard Iley

Macroeconomics

The time-varying term premium embedded in bond yields ensures that the Fed's ability to affect longer-term yields and, hence, overall financial conditions is more limited than many realise. This raises legitimate questions over the efficacy of the use of the short-term rates as the key policy tool over the longer-run.The 3% 10-year UST yield that was widely seen as inevitable only a few months ago now looks remote. An unlikely, though not implausible, sharp rise in the term premium of 50-70bp will be needed to get anywhere near those levels. But there appear few short term catalysts for such a move.Political dysfunction in Washington has dulled the prospect of pro-cyclical fiscal easing while risks to China are still skewed to the downside. Market participants' legitimate fears of negative policy rates and/or a renewed expansion of the Fed's balance sheet in the next 5-10 years (or even earlier) may also work to keep the term premium historically depressed. Given the historic elasticity between policy tightening and the expected average policy rate embedded in the yield curve, the Fed will likely need to keep hiking for longer and further than most forecasters assume if it wants to effect any meaningful tightening of aggregate financial conditions. If further policy tightening by the Fed is interpreted by market participants as increasing future downside risks facing the economy, it may simply serve to intensify the new bond market conundrum and underscore the central bank's relative policy impotence.More aggressive guidance and tactics about the size of its balance sheet may be the Fed's best strategy to establish better control over the longer-term interest rates that matter most to the economy.The current plan to shrink the balance sheet slowly and deliberately is strongly redolent of the Fed's 'measured pace' of rate hikes in 2004-2006 which is viewed as having unhelpfully damped the impact of policy tightening and so worked as an unintentional incubator of the subsequent financial crisis. As Mark Twain reputedly said, 'history does not repeat itself, but it does rhyme'.

The time-varying term premium embedded in bond yields ensures that the Fed's ability to affect longer-term yields and, hence, overall financial conditions is more limited than many realise. This raises legitimate questions over the efficacy of the use of the short-term rates as the key policy tool over the longer-run.The 3% 10-year UST yield that was widely seen as inevitable only a few months ago now looks remote. An unlikely, though not implausible, sharp rise in the term premium of 50-70bp will be needed to get anywhere near those levels. But there appear few short term catalysts for such a move.Political dysfunction in Washington has dulled the prospect of pro-cyclical fiscal easing while risks to China are still skewed to the downside. Market participants' legitimate fears of negative policy rates and/or a renewed expansion of the Fed's balance sheet in the next 5-10 years (or even earlier) may also work to keep the term premium historically depressed. Given the historic elasticity between policy tightening and the expected average policy rate embedded in the yield curve, the Fed will likely need to keep hiking for longer and further than most forecasters assume if it wants to effect any meaningful tightening of aggregate financial conditions. If further policy tightening by the Fed is interpreted by market participants as increasing future downside risks facing the economy, it may simply serve to intensify the new bond market conundrum and underscore the central bank's relative policy impotence.More aggressive guidance and tactics about the size of its balance sheet may be the Fed's best strategy to establish better control over the longer-term interest rates that matter most to the economy.The current plan to shrink the balance sheet slowly and deliberately is strongly redolent of the Fed's 'measured pace' of rate hikes in 2004-2006 which is viewed as having unhelpfully damped the impact of policy tightening and so worked as an unintentional incubator of the subsequent financial crisis. As Mark Twain reputedly said, 'history does not repeat itself, but it does rhyme'.

US: Bond Market Conundrum 2.0