Betting odds are beginning to smile on Lael Brainard as the next chair of the Federal Reserve.
Zach Gibson/Bloomberg
There’s a conundrum in the bond market. Bonds are rallying, sending yields—which move inversely to prices—lower, despite significant indications that things should be moving in the opposite direction.
Let’s take a step back. The yield on the benchmark 10-year U.S. Treasury note topped 1.7% in October, hitting its highest levels since April, when crossing that threshold prompted real cause for concern.
The blame game pointed to, among other things, the prospect of the Federal Reserve ending its bond-buying program and starting to raise interest rates, the debate over how long-lasting inflationary spikes would be, and frayed nerves over U.S. debt.
Those macro concerns haven’t gone away, but yields have fallen, with the yield on the 10-year Treasury lower again Tuesday at 1.44%.
In fact, some of those concerns have been confirmed, or even magnified.
The Fed announced this month that indeed it would begin slowing, or tapering, $120 billion in monthly asset purchases by $15 billion a month, with a target of ending the pandemic-era program to add liquidity to markets by next June. That sets the stage for possible rate hikes in the second half of next year, even as Fed Chair Jerome Powell hammered home that tapering didn’t mean a tightening of monetary policy—just yet.
Inflationary concerns remain. In fact, as he announced the plan to taper, Powell outlined how the central bank sees higher inflation persisting, eroding some of the argument that inflationary spikes were merely transitory.
“Tapering is likely to be followed by tightening if inflation remains persistent, which seems more likely now,” said economist Edward Yardeni of Yardeni Research in a report Tuesday, highlighting this conundrum in bonds. “Yet the bond market chose to focus on Powell’s most dovish pronouncements.”
To add to the pile, U.S. spending is still on a tear. The passage of the $1.2 trillion infrastructure bill by Congress last week—a hallmark of President Joe Biden’s economic agenda—should add some $256 billion to the budget deficit over the next 10 years, increasing inflationary pressures.
Yardeni proposed three possible reasons why bonds have continued to rally.
The first is that the Fed and banks are still buying bonds; tapering means the pace will slow but the punch bowl of liquidity is still getting topped up for now. Foreigners may also be buying U.S. bonds as an alternative to domestic bonds in places such as the U.K. and Germany.
But perhaps most interesting is that retail investors are buying bond funds, with cash from individual investors pouring into mutual funds and exchange-traded funds that hold bonds, according to Yardeni.
“The question is why would retail investors find bonds attractive at historically low yields?” Yardeni asked. “The answer might be that not everyone agrees that there is no alternative to stocks. Furthermore, as stock prices have soared, some investors may be rebalancing their portfolios out of stocks and into bonds.”
As bond yields remain depressed through the beginning of this week, there’s another factor at play: the future of the Fed.
Powell’s future as the head of the central bank looks increasingly uncertain. Betting odds, as per PredictIt, are beginning to be less favorable to Powell, with Fed Gov. Lael Brainard emerging as an underdog favorite.
“With each week that goes by, the failure of Joe Biden to renominate Powell shortens the odds that the Fed chair will not see a second term,” Louis-Vincent Gave, the CEO of Gavekal research, wrote in a note Tuesday. “This may help to explain the recent rallies in bonds and equities. If Powell is to be replaced, his successor is likely to be even more dovish.”
Brainard, a Democrat, is someone viewed as more dovish. But even if she succeeds Powell as Fed chair, it doesn’t mean Brainard would keep rates low for longer, allow inflation to run amok, and see bond yields continue to fall.
“The reality is actually more complex,” said Sebastian Galy, a macro strategist at Nordea Asset Management. “She will likely need to first turn more hawkish before reversing course.”
Galy describes the fundamental problem facing Brainard, or any successor to Powell: how to keep inflation under control while maintaining a solid pace of economic growth. That might not keep yields low forever.
“It should take a few weeks for this point to come through,” Galy said.
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