The US Federal Reserve is set to announce its interest rate decision early next month, and several officials of the US central bank have said the bond market is doing their job and they could afford to hold interest rates again.

US treasury yields have been at their highest in over 15 years, with the 10-year rising past 5% on Oct 23. The 30-year had hit 5.18%.

The 10-year yield was below 4% in August, and the recent surge has surprised many.

Treasury yields have been propelled higher in recent weeks, not only by expectations that the Federal Reserve will keep its policy rate elevated for longer than expected but also by growth in the supply of bonds and waning demand from central banks.

What has been particularly hurting the market is the Fed’s quantitative tightening, which has resulted in the Fed not replenishing bonds in its portfolio that have matured.

The market is now caught up with the Fed’s rate actions (500 basis point increase in 19 months) and balance sheet reduction.

Federal Reserve Chair Jerome Powell concurred.

“They’re (bond traders) revising their view about the overall strength of the economy and thinking even longer term it may require higher rates,” Powell said. “There may be a heightened focus on fiscal deficits. QT could be part of it.”

DOING THE JOB

An important variable that has changed since the Fed met in September is the sharp rise in bond yields.

Fed officials now seem to think they can afford to defer rate hikes as the bond yields seem to be doing their job.

This is despite their signaling of one more rate hike by December.

Federal Reserve Bank of Dallas President Lorie Logan said earlier this month that the recent surge in treasury yields may mean less need for the US central bank to raise its benchmark interest rate again.

“Higher term premiums result in higher term interest rates for the same setting of the Fed funds rate, all else equal,” Logan had said.

“Thus, if term premiums rise, they could do some of the work of cooling the economy for us, leaving less need for additional monetary policy tightening.”

San Francisco Fed President Mary Daly has said that bond yields have tightened, meaning financial conditions have tightened. “If that’s tight, maybe the Fed doesn’t need to do as much. That’s why I said, depending on whether it unravels or whether the momentum in the economy changes, that could be equivalent to another rate hike.”

The Fed’s Chairman Jerome Powell has said the recent run-up in long-term treasury yields could lessen the need for further hikes “at the margin”.

BUT IS IT?

In context related to his own country, Bank of Canada Governor Tiff Macklem said high bond yields are not a substitute for central banking action.

Macklem said higher long-term bond yields reflect expectations for future central bank policy. “They’re not a substitute for doing what needs to be done (now) to get inflation to come back to our target,” he said.

The same logic applies to the Fed.

What the Fed will do at its next meeting remains to be seen, but it could be dangerous to be mainly pushed by the market’s pricing of bonds to set policy – either to raise rates or to cut them.

The factors driving the bond market are simply the bloated budget deficit of the US government and its plan to intervene in the West Asia conflict if needed. Heavy borrowing by governments often boosts the economy and drives up inflation pressures.

Often, movement in bond yields could be temporary. A soft reading of inflation or employment numbers could bring the yields closer to 4.50%.

Barring the rise in government borrowing (including due to the conflict in West Asia), factors around the Fed’s stance haven’t changed much since August (when the 10-year bond was below 4%).

Many economists believe the term premium or high bond yields may be distinct from economic developments, and it would be best for the markets to react to the Fed instead of the Fed reacting to the markets.

Minneapolis Fed President Neel Kashkari said he wasn’t convinced that a surge in long-term treasury yields would lessen the need for further rate hikes.

Factors driving the bond yields become essential, he said.

“It’s certainly possible that higher long-term yields may do some of the work for us in terms of bringing inflation back down,” Kashkari said. “But if those higher long-term yields are higher because their expectation about what we’re going to do has changed, then we might actually need to follow through on their expectations in order to maintain those yields.”

There are enough reasons for the Fed to hold interest rates on Nov 1. The Fed, which is close to the peak of its rate-raising cycle, could be waiting to review more data, having raised interest rates by 500 basis points already.

High bond yields may be a pretext for holding out on rate hikes, and they may not necessarily be driving this call.

VICIOUS LOOP

By themselves, the rising US bond yields are a challenge to the world economy. There is this pernicious feedback loop.

The US dollar is rising because of treasury yields, hurting the inflation projections of energy importers, including India's.

In a recent note by its in-house economists, the RBI said the dollar’s strength is now a global risk.

Monetary policy authorities facing these combined pressures may remain on guard for longer – in fact, even rate pauses are accompanied by higher future rates guidance.

Even the government could be forced to increase their borrowings if the oil prices remain high. High crude oil prices could force the government to subsidize energy prices.

All this could, in turn, pressure the bond yields.

There is this vicious cycle, which could break if, as a first step, the tensions in West Asia cool off dramatically.