US economists say the bond market is testing the Federal Reserve’s inflation credibility, with higher long-term yields limiting support for the US Dollar.
The Federal Reserve has not lost control of the bond market. Not yet.
But the reaction to July’s policy meeting was uncomfortable enough to raise the question.
Short-dated Treasury yields fell as markets reduced expectations for near-term rate hikes.
Longer-term yields moved the other way, while inflation expectations rose and the US Dollar weakened.
Bank of America described the move as consistent with an “inflation credibility shock”.
“The nominal and real UST curves sharply twist steepened,” the bank said, after Chair Kevin Warsh suggested financial markets had already done some of the Fed’s tightening work.
That message did not land well.
Since the meeting, the US Dollar index (DXY) has fallen around 1.4%, despite higher yields at the long end of the Treasury curve.
Ordinarily, rising US yields would be expected to help the US Dollar.
This time, investors appear to have viewed the rise as compensation for inflation and policy risk rather than tighter monetary policy.
Bank of America said: “Markets responded by questioning the Fed’s credibility: long-end yields, and the Dollar sold off substantially.”
The bank’s Flow Show team went further, warning that financial conditions could continue tightening until the Fed is forced to restore credibility through more aggressive rate hikes.
It sees a risk of one of those unpleasant “higher yields-lower Dollar” episodes in which bond investors demand more compensation while confidence in policy deteriorates.
Natixis is less certain that matters have gone that far.
“We are not convinced that the Fed all of a sudden lost all its credibility,” the bank said, arguing that two trading sessions are not enough to reach such a firm conclusion.
Some of the move may simply reflect traders removing near-term hike bets, higher oil prices feeding into inflation expectations and poorly positioned investors being forced to adjust.
Still, Natixis admits the market reaction “does smell like 2022”.
“The market clearly did not like Warsh’s message that if the market tightens for him, the Fed may not need to do it themselves,” it said. “The market’s response was to then question the seriousness of his actual intent to hike.”
US Dollar Outlook: Credibility Test Could Force Fed Response
The immediate problem is that Warsh appears reluctant to guide markets back into line.
Natixis noted that previous Fed chairs might have used a speech or press interview to push back against an unwanted market move.
Warsh, by contrast, prefers markets to produce their own signals.
“To us, this means the market can run with this theme of a loss of credibility,” Natixis said.
Bank of America thinks that very challenge makes a September hike more likely.
“Ironically, we think the need to re-establish credibility increases the probability that the Fed will hike in September,” it said, maintaining its call for three 25-basis-point increases before year-end.
The Fed has not lost the bond market.
But it may have discovered that leaving markets to do the tightening comes with a price: higher long-term yields, a weaker Dollar and a growing demand for proof that inflation remains the priority.
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