Some thoughts on unanchored inflation expectations, Fed policy and rising 10-year yields

A month ago, 10-year yields were at 2.89%. And so, we were at a level that yields had been on February 20th despite two rate hikes in the intervening period. Since that time, rates have shot up 10 basis points, with the 10-year briefly crossing the 3% threshold earlier today. What are we to make of this?

1 – Look at the short-end, but not the very short-end

If you look at the 2-year, we see a 15 basis point uptick in the same time frame that 10-year rates have increased 10 basis points. So while some of the Fed’s tightening has fed through to the long end, the curve is still flattening. Right now, we’re at 21 basis points between the 2-year and the 10-year, whereas a week ago we were at 23 basis points. A month ago, the differential was 26 basis points.

It’s the medium-term part of the curve from 6 months to 2 years that is simultaneously sensitive to interest rate increases and interest rate expectations. There we see the Fed’s policy hikes feeding through entirely, without muted interest rate expectations dampening the rise. At the long end of the curve, interest rate expectations start to predominate. And so, we see curve flattening, as the Fed raises rates. And that indicates market expectations of material economic slowing that leads to a Fed pause in the medium term.

2 – Look at inflation

For the first time in 5 years, we are in a situation where the Fed has met its 2% inflation target.


And the inflation that consumers are feeling is even higher.


Now, Fed officials have repeatedly suggested rates above 2% are no more alarming than rates below 2% because the Fed’s policy is symmetric. So, ostensibly, a 2.4% inflation number is perceived by the Fed similarly to one that is at 1.6%.

The problem, however, is that headline unemployment numbers are very low. So, with the Fed charged with watching both inflation and employment, the Fed has to lean on the tightening side. That means that inflation above target is not the same as inflation below target because of the possibility of the economy overheating in the medium-term.

Moreover, with trillion dollar deficits adding a great level of stimulus and the economy growing well above 3%, the Fed is concerned about inflation becoming unanchored. That’s the big takeaway from Lael Brainard’s last speech. When she says that “the shorter-run neutral rate, rather than the longer-run federal funds rate, is the relevant benchmark for assessing the near-term path of monetary policy in the presence of headwinds or tailwinds,” that’s what she’s saying.

Brainard is basically saying that inflation expectations could become unanchored over the short-term, driving “the shorter-run neutral rate” higher and altering the near-term path of monetary policy.

The Fed will continue to have a tightening bias

With inflation rising and headline unemployment levels low, the Fed will remain on its front foot in tightening policy. Yes, they may take what they consider a gradual approach. But they have been dragging the market to their tightening rather than moving to the market’s view of future rate policy, which has suspicious of possible hiking. When the year began, the market was pricing in fewer than two 2018 rate hikes. Now it is moving toward four.

What happens in 2019 then? If the data hold, we will see a further acceleration of the Fed’s timetable. And the market will move to the Fed’s position. And that likely means a flattening of the yield curve, continued upward pressure on the US dollar, and problems for emerging markets and eventually riskier domestic debtors.

I continue to believe that 2019 will be the year the credit cycle turns. And the move up to 3% in 10-year rates only reinforces this view.

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