The Federal Reserve faces another bond-market conundrum as it prepares to raise interest rates.
Policy makers including New York Fed President William C. Dudley are suggesting there’s something wrong with debt yields that aren’t climbing as the economy recovers. Yet traders are signaling there’s little reason long-term Treasury yields can’t, and won’t, stay depressed.
History is on the market’s side. The spread between yields on 10-year Treasuries and the Fed’s overnight rate is right where it should be based on past norms. And, in the last four decades, it’s been unusual for investors to demand more compensation to own longer-dated debt when the central bank increases its key rate.
Perhaps the bond market’s most important message is that the Fed’s own forecast for how much benchmark rates will rise is still too high, even after central bankers lowered their estimates last month. The market is calling for 2 percent rates in 2018, almost half what the Fed sees.
The Fed has “been wrong for so long,” said Jeffrey Gundlach, founder of Los Angeles-based DoubleLine Capital, which oversees $73 billion in assets. “Their incremental input in what will happen in the future has been literally of no value, because the market’s pricing has been closer.”
The dilemma is reminiscent of the so-called “Greenspan conundrum” of 2004, when long-term yields kept falling even as then-Fed Chairman Alan Greenspan ratcheted up borrowing costs more than 4 percentage points. The market thwarted his attempts to tighten credit and curb excesses that contributed to the worst financial crisis in 80 years.
Yields on benchmark 10-year Treasuries fell again last week -- 0.12 percentage point to 1.84 percent -- as a government report showed employers in March added the fewest workers since December 2013. The 126,000 increase was weaker than the most pessimistic forecast in a Bloomberg survey, damping the outlook for the timing of a rate hike. The yield was little changed today at 1.83 percent at 12:13 p.m. in Tokyo.
Dudley, who is vice chairman of the policy-setting Federal Open Market Committee, said in a Feb. 27 speech “it would be appropriate to choose a more aggressive path of monetary policy normalization,” if bond yields stay too low after the U.S. central bank starts raising rates.
A New York Fed model that analyzes bond yields shows investors aren’t demanding any compensation for the risk that long-term interest rates will change. A measure known as the term premium has been negative off and on since 2012, the year the Fed started its third round of bond buying.