Fed minutes stay dovish, but don’t rule out taper by year-end

The Federal Open Market Committee (FOMC) has consistently tried to underline that rates would remain close to Zero, at least till the end of 2023.

Apr 08, 2021 09:04 IST India Infoline News Service

There has been a fairly intriguing situation in the US bond markets. The Federal Open Market Committee (FOMC) has consistently tried to underline that rates would remain close to Zero, at least till the end of 2023. Despite such assurances, the bond yields in the US continued to rally as can be seen from the chart below.
Chart Source: FactSet

The rally in bond yields has been relentless since August 2020. Despite repeated assurances from the Fed about dovish rates, the bond markets are perhaps reading more into it. As we shall see later, the bond markets are perhaps correct, but first let us look at the minutes of the FOMC March meet published on 07 April.

Key takeaways from the FOMC April minutes

The Fed Minutes still appear to hint at sustained dovishness.
  • The March meet reiterated that easy policy will stay until it produces visibly stronger employment and inflation. FOMC minutes have reiterated that it would go by actual data over a consistent period of time, rather than forecasts.
  • This implies that the economy may have to show substantially higher traction before the Fed would embark upon major policy changes like tapering asset purchases and rate hikes. Most likely the latter would follow after a gap.
  • The minutes also suggested that the current bond purchases by the Fed to the tune of $120 billion per month will continue as it provided substantial support to the economy and also to the US financial markets.
  • FOMC reiterated it would adhere to Outcome Based Guidance and wait till GDP growth stabilizes, unemployment touches 5% and inflation sustains above 2%. The focus will be actual GDP and inflation not projected GDP or inflation.
  • An important point in the minutes was that markets will get sufficient notice before the committee makes any changes to its stance. That means; the Fed is working towards a glide path for tapering and for rate hikes in the future.
  • What is more important is that the FOMC raised its outlook for median GDP growth from 4.2% to 6.5%. FOMC has also projected inflation to touch 2.2% by year-end, against its ideal target of 2% inflation.
  • Interestingly, the Fed officials interpreted the spike in bond yield as a reflection of stronger growth expectations rather than worries about inflation pressures or the risk of the Fed raising benchmark interest rates.
Why US bond yields are still hardening

The US bond yields across maturities have been either flat or hardening even on the day when the FOMC minutes were announced.

Bond Type YTM (07 April) One-day change
US 3-Month Treasury 0.018% +0.003
US 1-Year Treasury 0.058% +0.000
US 2-Year Treasury 0.153% +0.000
US 5-Year Treasury 0.866% +0.008
US 10-Year Treasury 1.670% +0.016
US 30-Year Treasury 2.359% +0.023
Data Source: Reuters

FOMC underlined that bond markets across maturities were pricing in an economic rebound as well as a pick-up in inflation. In fact, expectations of higher inflation and growth got a leg-up after Joe Biden committed $2.3 trillion to upgrading US infrastructure. However, unless the 10-year breaches the 2% mark, it cannot be interpreted as a signal of an imminent rate hike or even a taper.

Hardening inflation is the first signal

Bond yields are moving up despite dovish assurances from the Fed due to US inflation projections. The US CPI inflation for Feb-21 was 1.7%, highest in last 1 year. Mar-21 inflation could be still higher around 3% due to low base, so April will be the real test. The moral of the story is that inflation is certainly picking up in the US. The Fed is silent about potential higher inflation as it goes by reported data. But the bond markets are always anticipatory.

Then there is the liquidity push that could hit inflation. Apart from the $6 trillion that was infused by the Fed in CY2020, the Congress recently approved $1.9 trillion stimulus package, which puts more money in the pockets of Americans. In addition, President Joe Biden just unveiled a $2 trillion infrastructure plan. These could have a primary and secondary impact on inflation.

So, what is the bottom-line?

The question is, what happens if inflation sustains above 2% for next 3-4 months. Obviously, then the Fed cannot sustain low rates till 2023. Bond traders at Bank of America believe that Fed would be more methodical. It would start off by cutting back on the monthly $120 billion purchase of Treasury and mortgage securities even by end of 2021. Of course, the actual rate hikes may happen about 12 months after the taper, so there is time to adjust.

The worry for Indian markets is that the US economy could drag the Fed into rate hikes in the next 18-20 months and the RBI will have to prepare for that. After all, monetary divergence in this market is a much bigger risk for India.

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