Are investors afraid that the Federal Reserve is behind the curve in terms of fighting inflation?
When the Fed first announced its rate decision on May 4, bond investors didn’t show a great deal of reaction. The 50bps rate hike was as expected. But as investors looked more closely at the details, the prices of long-term bonds began to fall, and yields began to rise.
For starters, the Fed had just raised rates to 0.875%. That’s about one-tenth the rate of inflation. Moreover, the Fed appeared to take anything more than 50bps rate hikes off the table. So, the upward adjustment of rates might not happen as quickly as traders had priced just a few days earlier when Fed funds futures suggested a significant likelihood of a 75bps hike in June.
When it comes to balance sheet reduction, the Fed seems unhurried. Previously, Fed officials had suggested that they could begin reducing their balance sheet by $95 billion per month as soon as May. But now they have made it clear that balance sheet reduction won’t begin until June, and for the first three months, they will only reduce it at a pace of $47.5 billion per month.
Over the next few weeks, it will be key to see what happens to inflation expectations and bond yields. If Treasury yields stabilize or fall, it might be seen as a signal that investors are happy with the pace of tightening, but further rises in yields might signal that investors are worried that the Fed is falling further behind the inflation curve.
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