Last Wednesday, the Federal Reserve of the United States (Fed) held its FOMC meeting and delivered its economic projections for the period ahead. The message was that the Fed keeps the monetary policy accommodative due to extreme uncertainty generated by the pandemic.
Heading into the meeting, the Fed was pressured by financial markets due to the rising real rates. Yields on long-term bonds rallied recently on increased optimism and consumer confidence. As such, financial conditions are tightening against the Fed’s wish.
So the Fed had an almost impossible mission – how to signal that it will stay put while the economic optimism is on the rise?
Understanding Real Rates
For traders, the real rates in the United States are crucial in interpreting the economic performance. Moreover, the global implications of rising or falling bond yields in the United States make the bond market the most important market to watch.
Trading the bond market is not for the retail trader. This is an expensive market with a lack of liquidity. However, the movements in the bond market trigger sharp reactions in the currency market and other financial assets too.
Bonds have a price when they are issued, and they also have a yield. The yield tells you how much the bond will pay in addition to the principal amount. The higher the yield, the more attractive the bond.
Yields have an inverse relationship with the price of a bond. During recessionary times, investors find refuge in bonds due to the uncertainty ahead. As such, the yields are falling while bond prices are rising.
The opposite happens when the economy recovers. Investors are willing to put their money into riskier assets, thus exiting the bond market. The move leads to higher yields as confidence increases, but it also leads to tightening financial conditions.
Because the U.S. yields are the benchmark for the entire world, a move higher or lower triggers a similar reaction from other yields in other markets. For example, the European Central Bank (ECB) and the Reserve Bank of Australia (RBA) had to react to the rising yields in Europe and Australia that created unwanted tightening imported from the U.S. markets.
The key moving forward is to see how much higher the Fed will let the yields rise. More precisely, what is the level that the yields would reach before the Fed saying “enough is enough”?