January 31, 2018 / 9:46 PM / 5 months ago

Breakingviews - Bond market tightening complicates Powell’s task

WASHINGTON (Reuters Breakingviews) - Bond market tightening will complicate Jerome Powell’s task. U.S. Treasury yields rose to near four-year highs even as the Federal Reserve left policy unchanged at Janet Yellen’s last meeting. But a fresh growth spurt and worsening deficit outlook will pose a serious challenge for her successor.

The U.S. Federal Reserve building is seen in Washington June 29, 2011. REUTERS/Jim Bourg

Yields had drifted slightly lower for most of last year even as the Fed raised its policy rate three times. Subdued inflation and continued heavy bond-buying by other major central banks played a big role. But the market has tightened significantly in the past six weeks, with the yield on the U.S. Treasury’s benchmark 10-bond nearly hitting 2.74 percent on Wednesday afternoon, the highest level since April 2014.

The recently passed U.S. tax cuts have helped alter the picture, putting the budget deficit on track to rise to nearly $1 trillion in 2019 and giving a fresh impetus to growth and potentially inflation. The Federal Open Market Committee suggested as much in its statement, saying members expected inflation would “move up this year” before stabilizing around its 2 percent target. Market expectations have also firmed, with the yield differential between the 10-year Treasury and similar inflation-protected bonds reaching its highest level since 2014.

Rising bond yields have a direct impact on the economy because they influence the rates companies pay to borrow and consumers pay on their mortgages. That may in part explain why both the S&P 500 Index and Dow Jones Industrial Average declined earlier this week and the CBOE Volatility Index jumped briefly above 15 for the first time in more than five months.

The market jitters hint at the challenges to come for Powell. Yellen accomplished no easy feat by engineering a gradual rise in interest rates without derailing the recovery. But Powell will soon face the very different, and arguably more difficult, task of setting monetary policy for an economy with near-full employment, somewhat rising inflation and soaring asset prices.

Investors are scouring for any hint that the Fed might raise rates by more than the three hikes it has already penciled in for this year, starting at its next meeting in March. Faster rate rises could spook markets and send yields climbing further. The next Fed chairman may be inheriting a strengthening economy, but that doesn’t make his job any easier.

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