The Fed’s Mixed Messaging on the Yield Curve
Last week’s FOMC meeting showed that the Federal Reserve (Fed) intends to maintain rates at zero even when the economy overshoots traditional measures of full employment and price stability. But Fed Chair Jay Powell stopped short of pushing back on the bear steepening of the Treasury curve.
Powell is giving conflicting guidance to bond investors. Dovish forward guidance is bullish for the short end while the Fed’s efforts to lift inflation expectations have been bearish for the long end. The belly of the curve is caught in the middle.
The question investors face is whether the selloff has more room to run. Our analysis suggests it has largely run its course. The market is now pricing in a neutral rate of 2.35 percent, nearly in line with the Fed’s optimistic long run dots. The chart below shows that the bond market has had difficulty sustaining rates at or near the Fed’s neutral rate projection, and we see no reason to expect a different result this time. Nor do we expect the Fed to revise up its neutral rate estimate.
The Fed's Optimistic Neutral Rate Projection Is Almost Fully Priced In
Source: Guggenheim Investments, Bloomberg. Data as of 03.19.2021. FOMC neutral rate projection is the median "Longer Run" dot from the Summary of Economic Projections. Market neutral rate projection is the 5-year forward 5-year Overnight Index Swap rate. Fed Funds Rate is depicted using the interest rate on excess reserves.
While the Fed has succeeded in lifting growth and inflation expectations, it now has a different problem: the market is pricing in premature rate hikes, as the chart below shows. The upshot for bond investors is that the steeper yield curve now offers an attractive carry and rolldown profile. If the Fed is as patient as we expect it to be, total returns for core fixed income investors have the opportunity to be much better going forward than they have been in the recent past.