Preventing a simmering economy from boiling

Seeing the yield on the 10-year Treasury hover above 3%, whether the result of a low-volume trading day or the Federal Reserve’s taper policy, is a psychologically significant event that the Fed will be closely watching.
“I’d call it a milestone to see the 10-year yield above 3%,” said Robert Tipp, chief investment strategist for fixed income at Prudential Financial.
“The Fed’s tapering decision represents a huge technical adjustment for the bond market,” he added. “When the majority of Federal Reserve Board members agree that it’s time to start tapering, it makes a lot of economists question their earlier assumptions, and now people are starting to wonder if maybe there will be fewer economic headwinds next year.”
As with most financial market milestones, this one is represented by just another number. Fact is, the 10-year’s current 3.01% yield is only 2 basis points higher than the 2.99% yield reached by the 10-year Treasury on Sept. 6.
But, also as with most financial market milestones, it is the psychological impact that matters most.
“Basically, the economy now is simmering because we’re moving in a positive direction but if we heat up too much, interest rates will start to move too quickly,” said Wilmer Stith, co-manager of the Wilmington Broad Market Bond Fund.
It is pure economic jujitsu. On the one hand, rising rates and a steeper yield curve means the economy is stronger.
But, too much of that too quickly and suddenly the economy is at risk of stalling again.
“The main concern right now is whether the positive data trend continues into the first quarter,” said Vishal Khanduja, portfolio manager at Calvert Investments.
“People are feeling more confident about the economy and putting more money into risk assets,” he added. “But Treasury yields are really made up of three things: GDP, inflation and inflation expectaiotns.”
Since both inflation and inflation expectations are actually going lower, it stands to reason that economic growth is currently the lone driver of Treasury yield.
So, the Fed is dealing with both the risk of too much enthusiasm related to the reason for tapering while actually tiptoeing into a tapering mode in the hopes the economy is strong enough to grow on its own without the artificial stimulus of the central bank’s bond buying.
“The tapestry of a stronger, more sustainable economy, is taking place. Unfortunately, two Fridays from now, we’re going to hit the reset button with some fresh payroll data,” Mr. Stith said. “If unemployment stays the same or moves higher, then all the other stuff doesn’t really matter, because the most important statistic to the Fed is payroll data.”

Related Topics: Federal Reserve