By Gertrude Chavez-Dreyfuss and Laura Matthews
NEW YORK, Oct 29 (Reuters) – The Federal Reserve kept interest rates steady on Wednesday as expected, but it was not able to comfort bond investors concerned about what a deliberate pace of policy tightening will mean for the outlook for longer-term government bonds.
The central bank described an economy strong enough to keep inflation elevated, yet refrained from raising rates immediately. That deepened uncertainty over how much further policy may need to tighten, analysts said, and over how much compensation investors could demand to hold longer-dated Treasuries, which have soared this year to their highest yields in two decades.
The Fed upgraded its assessment of the economy to “strong” from the “solid” expansion seen as of the September meeting, while describing investment as robust and job gains as keeping pace with the workforce. But how that all leads to price pressures coming down – the main priority for bond investors – was less clear.
“Ultimately, if we see strong growth, which (Fed Chair Kevin) Warsh is expecting, we’re going to see more inflation, which means those fiscal deficit concerns and how to address them longer term become more relevant,” said Anders Persson, chief investment officer for global fixed income at investment manager Nuveen in Charlotte, North Carolina.
LOOKING AHEAD TO MORE COMPLICATED TIMES
A combination of resilient economic growth and persistent inflation could complicate the US fiscal outlook, limiting the Fed’s ability to lower interest rates when the economy turns and keeping Treasury borrowing costs elevated.
The yield curve steepened following Warsh’s press conference, with the long end selling off. The spread between 2- and 10-year yields widened to as much as 34.1 basis points after flattening over the last few weeks.
There were different interpretations as to why. One was that Warsh did not give a definitive commitment on future policy action, which reduced rate-hike bets. He also suggested the Fed’s last rate increase is starting to work and that financial conditions have started to tighten.
The resulting steepening of the US Treasury yield curve, however, underscores the growing tension between a Fed that is willing to wait for more evidence before adjusting policy and investors increasingly concerned about persistent price pressures and the risks of holding long-term government debt.
Treasury yields have climbed across most maturities from the belly of the curve – between 5 and 7 years – onwards following the Fed’s latest decision, with longer-dated yields coming under particular pressure.
“The bond market selling off is because the Fed is going to have a hard time raising rates much higher without causing issues somewhere,” said Byron Anderson, head of fixed income at Laffer Tengler Investments in Scottsdale, Arizona.
The long-end selloff suggested that investors are also grappling with more than just the immediate outlook for monetary policy, analysts said, amid inflation uncertainty and fiscal concerns threatening to keep long-term borrowing costs elevated.
“Investors should prepare for interest rates to remain elevated with the Fed focused on bringing inflation back towards its 2% target,” said Phil Blancato, chief market strategist at wealth management firm Osaic in New York.
Financial markets are already pricing in the possibility of another increase in December, with expectations for further hikes next year adding to uncertainty over the policy outlook.
FED MISREADING STRENGTH OF ECONOMY?
Market participants also questioned the Fed’s assessment of the economy.
“What are they looking at to give the economy an upgrade? The moving average of weekly payroll gains from ADP was trending up between the July and September meeting, but it has been trending down since,” said Brian Jacobsen, chief economic strategist at Annex Wealth Management in Menomonee Falls, Wisconsin.
“The Atlanta Fed’s GDPNow forecast has gone from white hot to merely smoldering,” he said.
As growth loses some steam, the economy may not need to weaken much to undermine the optimistic outlook, according to some observers.
Citigroup’s chief US economist, Andrew Hollenhorst, said Warsh was “overstating the breadth of strength in the US economy, meaning he will likely have a relatively low bar for a downside surprise.”
That uncertainty over the economic outlook can weigh on Treasuries at the front end of the curve, where yields are particularly sensitive to rate moves. But the pressure on longer-dated bonds reflects a broader set of concerns.
Investors holding 10-year and 30-year Treasuries face greater exposure to changes in inflation expectations and interest rates over time. When uncertainty rises, they may demand additional compensation to take on that duration risk, pushing yields higher and bond prices lower.
If investors become less confident about the long-run inflation outlook or demand greater compensation for the government’s borrowing needs, the term premium – the extra compensation investors require to hold longer-term bonds – can rise even without a corresponding change in expectations for the Fed’s policy rate.
Nuveen’s Persson said “the concerns around pressure on the fiscal outlook” are what is driving the long end of the curve.
(Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Suzanne McGee in Rhode Island, Saqib Iqbal Ahmed, Saeed Azhar and Lewis Krauskopf in New York; Editing by Colin Barr and Jamie Freed)
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