Macroscope | A bombshell is waiting to hit the US bond market
If Fed comes under legislative pressure to dump QE assets, yields could rise very sharply
The US bond market seems a relative haven of security right now, bolstered by low interest rates, supportive central bank policies and flight-to-quality flows into US Treasuries.
US long bond yields remain close to multi-year lows and this is providing a vital boost to the United States’ economy, keeping borrowing costs low for consumers, businesses and investors. It could soon be about to change.
For the past 35 years, the US bond market has been locked into a super-cycle of falling yields. The bull run should have expired years ago, but the meltdown in global financial markets since 2008, US interest rates crashing down to zero, the Federal Reserve’s quantitative-easing-driven bond buying spree and investors rushing into safe-haven US government debt have given the market an extended lease of life. US bonds have defied the laws of gravity for far too long.
The market would be unwise to underestimate a central bank that has deliberately erred on the side of caution for so long
The trend towards higher interest rates is already long overdue and the Fed will “normalise” monetary policy as soon as the fundamentals allow. For the moment, it is treading carefully due to international economic uncertainties, but that could change quite quickly as higher inflation starts to lock in. With the jobs market surging and US core inflation already at 2.3 per cent, there is a credible case for higher rates ahead. The Fed will not waste a moment to press for tightening if its inflation-fighting credentials are put in any doubt.
The market would be unwise to underestimate a central bank that has deliberately erred on the side of caution for so long. Fed forecasts show quite clearly the central bank’s leaning for short-term interest rates heading towards 3 per cent in the next few years. But the real bias must be even higher considering the Fed’s wish to lock down future inflation risks with rates closer to the 4 per cent to 4.5 per cent range normally associated with neutral monetary policy. It would definitely be a shock for markets accustomed to near zero rates for the past six years.
A much bigger systemic risk is the Fed’s future plans for unwinding its stockpile of QE purchases, consisting of Treasuries, agency and corporate debt. Right now, the Fed’s balance sheet assets stand at around US$4.5 trillion, which it is keeping constant for now. This cannot go on forever and once disposals start in earnest there will be adverse market consequences. US bond yields and credit spreads will head sharply higher.
This could bode quite badly for global economic confidence. In the US, consumer confidence and spending could take a very heavy knock from higher mortgage costs and the housing market could be badly set back. Higher borrowing costs will hit US businesses and put a dent in output, investment and hiring plans. The Fed’s forecasts for gross domestic product growth of just over 2 per cent a year over the next three years would look far more dubious.