Is the Bond Market Pricing in a Fed Policy Error?

After months of carefully communicating the Federal Reserve’s (Fed) plan to reduce its asset purchases toward the middle of 2022, Fed Chairman Jerome Powell seemingly sped up that timetable during his Congressional testimony last week. While not officially announced policy yet, the expectation is that the Fed will now accelerate its tapering plans and end its asset purchases altogether by March or April of next year. Markets took this hawkish pivot as a sign that the Fed would also accelerate its plans to increase short-term interest rates. As a result, we’ve seen a notable reaction out of the Treasury market recently.

“We’ve seen a lot of volatility out of bond markets recently, but we think the markets are getting ahead of themselves here,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Next week’s Fed meeting is an important one and one that will hopefully help calm markets.

As seen in the LPL Research Chart of the Day, the yield curve has flattened recently as the spread between short-term and long-term Treasury yields has narrowed significantly to the lowest levels since December 2020. As a reminder, the shape of the yield curve is an important economic barometer and is seen as a reliable predictor of recessionary risks. That is, as the spread between short-term and longer-term interest rates narrows, the probability of recession has historically increased. Moreover, an inverted yield curve, when that spread becomes negative, has been one of the strongest signals that a recession is likely to occur over the next twelve months. hile we’re still a long way from full inversion, the yield curve flattening as aggressively as it has—before the Fed has even started to raise interest rates—may be a sign that the Fed won’t be able to hike rates too much before negatively impacting economic growth.

Last week’s “Powell pivot” and the resultant action in the bond market makes next week’s Fed meeting all the more interesting. With the yield curve flattening as drastically as it has, Powell may need to reassure markets that the Fed won’t raise short-term interest rates as aggressively as markets are expecting. We continue to think the inflationary pressures that have caused the recent hawkish shift will abate over the course of next year, which should allow the Fed to hold off on aggressive rate hikes. As we point out in our 2022 Outlook: Passing The Baton, we think the Fed would like to be patient in removing monetary accommodation but a Fed policy error is a risk that we continue to watch out for.

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