Interest rate forecasts from Federal Reserve officials sparked mixed reactions in US bond markets on Wednesday, suggesting investors still have questions about how much the central bank will actually tighten monetary policy.
Selling short-term treasuries showed that investors have once again raised their expectations about how high interest rates could rise this year. However, initial sales of long-term bonds quickly fizzled out, suggesting that investors thought the rapid pace of interest rate hikes over the next few months could lead to a smaller increase later.
Stocks rose, with the S&P 500 up 2.2% and the high-tech Nasdaq Composite up 3.8%.
In line with investor expectations, the central bank on Wednesday raised its benchmark federal funds rate from near zero to a range of 0.25% to 0.5%. Officials, though, have also substantially raised their forecasts for how high rates will rise over the next few years.
Overall, 12 out of 16 officials indicated that they believe rates will reach a range of at least 1.75% to 2% by the end of the year, with an average forecast of around 1.9%. The median forecast for rates by the end of next year was about 2.8%.
“The Fed has sent a strong message to the market that it has the commitment and willpower to bring down inflationary pressures,” said Gary Pollak, head of fixed income trading at Deutsche Bank’s private wealth division.
He added that investors were already thinking that the central bank might raise rates at each of its remaining meetings this year. But they also bet that the Fed itself would signal more caution in its forecasts on Wednesday, which caused short-term bond prices to fall and yields to rise when the forecasts were released.
By the end of the session, the benchmark two-year Treasury yield settled at 1.956%, according to Tradeweb, compared to 1.855% on Tuesday. The 10-year yield settled at 2.185%, the highest level since May 2019, but only a modest rise from 2.160% on Tuesday and little changed from just before the Fed’s announcement. The yield on 30-year bonds fell to 2.456% from 2.503% on Tuesday.
In some ways, analysts said, Wall Street’s reaction was in line with recent trends: Investors are ready to adjust their interest rate expectations for 2022, but they will be much less flexible after that.
As for 2023 and 2024, investors are “really skeptical,” said Priya Mishra, head of global rate strategy at TD Securities in New York. “It’s further,” she added. “Everything can change. Perhaps by then inflation will indeed come down,” especially given what the Fed is likely to do this year, both in terms of raising rates and cutting its bonds.
Investors and economists pay close attention to Treasury bond yields because they set a floor on the cost of borrowing across the economy and are an important input to the financial models that investors use to value stocks and other assets.
Heavily influenced by investors’ expectations of short-term rates set by the Fed, changes in yields can have a direct impact on the economy long before the central bank actually changes the rates it controls directly. Already this year, there have been signs of a slowdown in demand for housing due to rising mortgage rates, which are closely related to the yield of 10-year Treasury bonds.
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Many investors will accept somewhat slower economic growth as long as the US can avoid a recession and corporate profits continue to rise. US stocks generally performed well when the Fed began raising interest rates, largely because the central bank took these steps when the economy was in a strong position.
Investors are more nervous than usual this year, with the S&P 500 down 8.6% for the year as inflation is higher than it has been in decades. One risk is that the Fed could risk a recession, or accidentally cause one, in an attempt to tame inflation.
This year has already been a challenging one for bond investors. When inflation started picking up last year, investors thought for several months that it might come down on its own, allowing the Fed to keep short-term interest rates near zero. Those views, however, have changed rapidly this year, largely due to a change in the tone of Fed officials, including Chairman Jerome Powell, who has begun to express more worries about inflation and a desire to start raising rates.
This year, a significant rise in bonds came at the end of February when Russia invaded Ukraine for the first time, causing uncertainty about the economic outlook.
Recently, however, investors have become more skeptical that the invasion could keep interest rates down. Some argue that higher commodity prices caused by the invasion could only fuel inflation further, putting even more pressure on the Fed to tighten policy. Meanwhile, energy prices have already eased from recent highs, thanks in part to hopes for a negotiated settlement between Russia and Ukraine. This eased the worries of those who believed that higher prices could have the opposite effect of slowing economic growth and making it harder for the Fed to raise rates.
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Regardless of the Fed’s actions on Wednesday, monetary policy, and thus bond yields, will continue to be largely determined by the state of the economy.
On that front, new data showed Wednesday morning that retail sales rose a seasonally adjusted 0.3% in February, below analysts’ forecasts of a 0.4% increase. At the same time, sales growth for January was revised upward to 4.9% from 3.8%.
Treasury bond yields were virtually unchanged immediately after the release of the report. In a note to clients, Jan Lingen, head of US rate strategy at BMO Capital Markets, wrote that the data showed a “worrisome trajectory” but that an upward revision in January sales “softened disappointing February data.”
Write to Sam Goldfarb at [email protected]
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