The Federal Reserve's pledge to curb inflation appears to have resonated with the market. If the central bank raises rates as much as recent projections indicate, the risk of recession rises. Consequently, bond yields have been pulling back from recent highs and the yield curve has flattened.
It's fair to say that earlier this year, central bankers were struggling to communicate their intentions clearly to the markets. However, that doesn't appear to be the case any longer. In the United States. Federal Reserve Chair Jerome Powell and the members of the Federal Reserve's policy-making Open Market Committee (FOMC) have been steadfast in signaling their commitment to fighting inflation. If there is a communication problem, it's mostly that central bankers don't want to admit out loud that getting inflation down raises the risk of recession.
European Central Bank (ECB) President Christine Lagarde is facing an even more difficult problem. The ECB wants to raise rates due to rising inflation stemming from the spike in energy prices. However, the data suggest that Europe's economy is weakening—largely due to the rise in energy prices. Meanwhile the ECB also wants to limit the widening in bond spreads between core and peripheral countries as markets focus on recession risks in countries with high debt levels. Talk about a policy dilemma.
Not to be left out, Bank of Japan (BOJ) President Haruhiko Kuroda has had to apologize repeatedly over the past few weeks for saying that Japanese consumers don't mind rising inflation stemming from the yen's steep drop. The problem is that the BOJ is trying to have it all ways. It wants to maintain its zero-interest-rate policy and yield-curve control, while also preventing the yen from falling to a new multi-decade low.
Not surprisingly, markets have been roiled by these confusing and sometimes circular arguments coming from central bankers. But in my view, the bond market has it figured out. Since the Fed's last meeting, Treasury yields have fallen across all maturities. In fact, short-term yields peaked on the first day of the Fed's last meeting, when the federal funds rate was raised by 75 basis points (or three-quarters of a percentage point).
The yield curve has flattened since the last FOMC meeting
Source: Bloomberg, data as of 6/14/2022 and 6/30/2022.
Past performance is no guarantee of future results.
It looks like the Fed's actions and pledge to bring inflation down have resonated with the market. If the Fed follows through in hiking rates as much as the recent projections indicate, the risk of recession rises. Consequently, bond yields have been pulling back from recent highs and the yield curve has flattened.