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Bond Traders Suspect Fed Is Flirting With Policy Error

By Lisa Abramowicz

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(Bloomberg Gadfly) — The Federal Reserve is getting closer to making a policy error.

That’s the message bond traders sent on Wednesday when the Fed raised overnight borrowing costs for the second time this year. That was widely expected. What was less anticipated was the signal from U.S. policy makers that they still plan on an additional interest-rate increase this year despite relatively weak economic data of late. At the same time, the Fed gave more details about its plan to start unwinding its behemoth balance sheet later in 2017. 

(Related: Fed Raises Rates, Lays Out Plan to Cut Balance Sheet)

All these moves are aimed at increasing borrowing costs to bring them more in line with historical norms. In the past, the Fed tightened monetary policies to slow growth and tamp down inflation, but that’s not what’s going on here. Instead, U.S. central bankers are clearly worried about easy-money policies fueling a seemingly endless rally in riskier assets and the paucity of ammunition to lower rates the next time the economy sours.

But the bond market’s response showed that the Fed is neither boosting longer-term benchmark borrowing costs nor dampening appetite for riskier assets. Yields on 10-year and 30-year Treasuries plunged after several measures of expected inflation and growth over the longer term fell, and they ended the day lower after the Fed’s announcement.

In other words, the Fed’s moves have given it little room to drop rates in the future while dimming the outlook for economic expansion in years to come. That looks a lot like a policy error.

The Fed is in a difficult spot right now. Not only is it trying to normalize policies at a time of unimpressive economic growth, but it is doing so as its fellow central bankers in Europe and Asia maintain ultra-easy monetary policies, thus pushing investors into less-creditworthy stocks and bonds. It’s unclear how much power the Fed has to unilaterally squelch this rush to yield, which has pushed valuations to concerning levels.

What these central bankers need to validate their moves is inflation, and that’s proving remarkably elusive. Perhaps that’s because oil prices have been relatively low in recent years, but there are also indications that consumers aren’t spending quite as much, another concerning signal for the months ahead.

Bond traders are clearly worried that U.S. central bankers are on a path to harm the nation’s prospects for growth without meaningfully adding to its arsenal of tools to deal with any downturn. The debt markets have an uncanny ability to be more right than wrong. It’s worth paying attention to their message.

— Read Who’s Driving Fed Policy? Most Voting Seats Are Empty on ThinkAdvisor.

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