The Federal Reserve may think it’s sounding more hawkish these days, yet the debt markets don’t quite buy it.
Traders are pricing in less than the three quarter-point rate hikes that officials have signaled as likely this year, and the market is still far from the four increases that some economists are predicting. That’s even after minutes from January’s policy meeting released Wednesday showed central bankers see the economic momentum to plow onward with more tightening.
What’s more telling is that long-term Treasury yields shot higher in reaction to what some say is a warning that the Fed may be risking inflation running too hot by staying the course of only gradual rate hikes.
“The bond market is telling the Fed we see rising inflation pressures and if you are going to be gradual and crawl into three more rate hikes this year we are not going to wait around,” said Peter Boockvar, chief investment officer of Bleakley Financial Group. “The long end of the yield curve is tightening for the Fed.”
With concern growing among some that the Fed’s actions might enable inflation to bubble up further, longer-term Treasuries underperformed short-dated debt Wednesday, steepening the yield curve. The gap between 2-year and 10-year yields widened to 68 basis points Wednesday from 66.7 basis points a day earlier. The spread is 66.5 basis points now.
The benchmark 10-year yield is trading above 2.92 percent, close to a percentage point higher than its 2017 low, after reaching a four-year high of 2.9537 percent after the minutes were released Wednesday.
Overnight index swaps, contracts used to wager on the trajectory of the U.S. central bank’s target rate, are not fully pricing in three hikes at the moment, although two are seen as a near certainty by the market. OIS contracts also show that for 2019 the market is pricing in less than the nearly two hikes indicated by the Fed’s dot plot, which tracks policy makers’ projections.
U.S. central bankers said in the minutes of their January gathering that an expansion with “substantial underlying economic momentum” could sustain additional increases in interest rates this year. Their collective position on inflation, meanwhile, remained one of cautious optimism that it will move up toward their 2 percent target in the medium term.
There was some disappointment that the minutes didn’t imply that the central bank might boost its target rate four times this year, as economists from firms including JPMorgan Chase & Co. and Goldman Sachs Group Inc. have predicted.
Jan Hatzius, chief economist at Goldman Sachs, said Thursday during a Council on Foreign Relations event in New York that he sees overheating as the biggest risk. According to Hatzius, the Fed should be working against this -- and hiking even faster. While there is a “low probability” they lift rates five times in 2018, they may speed up the pace next year, he said.
The market outlook for consumer prices gains over the next 10 years, as measured by breakeven rates on Treasury Inflation Protected Securities, has risen to 2.12 percent from 1.98 percent at the end of last year. Breakevens have been inching higher following reports that showed faster-than-expected advances in the consumer price index and average hourly wage earnings in January.
The inflation gauge that Fed officials prefer to use has been below 2 percent through most of the last six years. Prices rose 1.7 percent in the 12 months through December, according to the Commerce Department’s personal consumption expenditures measure.
America’s labor market and inflation picture is sufficiently strong to back the central bank lifting rates four times this year, Dan Fuss, vice chairman of Loomis Sayles & Co. said in an interview. Yet they won’t, in part because the Fed doesn’t want to stomp out the recovery, he said. That gives more upside to inflation and long-term Treasury yields, according to Fuss.
“My instinct is that the Fed will move more or less in line with their dot plot,” said Fuss, whose firm has $268.1 billion in assets under management. “The pressures are still to the upside for both 10- and 30-year Treasury yields.”
Some analysts say the spike Wednesday in long-term Treasury yields was more about hedging, positioning and investors demanding a greater premium for risk.
“Judging from our conversations with investors, there seems to be fear of missing a very big trade opportunity, so we wouldn’t be surprised if investors took the optimistic tone of the minutes as an opportunity to put some short positions back on,” Robert Perli of Cornerstone Macro wrote in a note Thursday.
All this together has most traders not seeing the Fed doing anything that slows the gravitational pull higher of long-term Treasury yields -- with the key 3 percent level for the 10-year note on the radar.
“You could make the argument that the Fed minutes were dovish as they didn’t foretell four hikes like many expected,” said Glen Capelo, head of rates at Academy Securities. “It doesn’t matter to me if it’s three or four hikes, bottom line is that rates are all going higher.”
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