An age-old debate among fixed-income investors is whether the Federal Reserve (Fed) leads or follows the bond market. Last week’s market action left no doubt about which one was in control, as a significant shift in Fed messaging pushed yields across the curve to their highest levels since the onset of the pandemic.
Recent communication from the Fed (which appears to be well coordinated by Fed Chair Jerome Powell) has indicated a willingness to shrink its nearly $9 trillion balance sheet more quickly, while increasing rates more gradually. This change was a clear response to monetary policymakers’ disappointment with the recent decline in long-term Treasury rates and flattening of the yield curve after the Fed indicated more aggressive tightening would be required to bring down inflation.
Barring any new setbacks caused by the ever-changing COVID-19 pandemic, I expect 10-year Treasury yields will soon break through the 2% level as the Fed continues to use the power behind its massive balance sheet to lead the bond market.
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