Will the Fed push back against higher bond yields?

The Federal Reserve convenes for its policy meeting this week at a pivotal point for the US economic recovery, prompting speculation about its plans to manage a rise in borrowing costs.

Since its previous gathering in late January, trading conditions in the nation’s $21tn government bond market have at times turned choppy.

Yields, which rise as prices fall, have shot higher, and the benchmark 10-year note now trades at a 13-month high above 1.6 per cent. The swift surge has rattled equity markets, especially the high-flying technology sector that has benefited from historically low interest rates.

The moves reflect growing optimism among investors about the pace of the economic recovery, but also percolating fears that the Fed may raise interest rates at a faster pace than many anticipate. 

Inflation expectations have soared since the start of the year, with one market measure — the five-year break-even rate — rising to a level last seen in 2008, at 2.6 per cent. 

Jay Powell, Fed chair, attempted earlier this month to play down speculation that the Fed would prematurely adjust its policy. But investors said his reluctance to push back more forcefully against the recent sell-off in Treasuries has helped to knock yields higher.

Strategists at Société Générale have since revised higher their rates forecasts, predicting that 10-year yields will rise to 2 per cent by the end of the year. 

“The Fed will likely tolerate higher yields if fundamentals continue to improve and financial conditions remain accommodative,” they wrote in a recent note. Colby Smith

How will the Bank of England react to rising inflation expectations?

The Bank of England faces a very different market environment on Thursday to the one at its previous interest rate-setting meeting in early February.

In the intervening six weeks, global financial markets have been unsettled by a sharp rise in inflation expectations following a vaccine-fuelled improvement in the economic outlook. In the UK, yields on 10-year gilts, which rise as prices fall, have jumped from less than 0.4 per cent to close to 0.8 per cent in reaction to inflation concerns.

That leaves the bank’s Monetary Policy Committee with the task of deciding how and when to tackle a possible resurgence in inflation. Last week Andrew Bailey, BoE governor, said the risks of rising inflation were “increasingly two-sided”, although he said the bank was not about to raise rates.

Last Thursday, the European Central Bank took action in response to higher borrowing costs, saying that its bond buying would take place at “a significantly higher pace” over the next quarter.

However, Ruth Gregory, Capital Economics’ senior UK economist, said she did not expect the BoE to follow suit on Thursday. Instead, she said it would reiterate its guidance that rates would not rise for some time.

Peter Sleep, senior portfolio manager at 7 Investment Management, said Bailey’s comments were “kidology” designed to make sure borrowers did not get complacent that rates would stay low forever.

“I think that although things are improving, the economy still has a lot to do before it gets back to a level where there is full employment or inflation becomes a threat,” Sleep said. Laurence Fletcher

Will the yen continue to weaken against the dollar?

Last week the dollar-yen rate — the currency pair known on trading floors as the “paymaster” — settled into an elevated range of around ¥108 per dollar, edging above ¥109 on Friday.

The weakening in the Japanese currency against the US dollar rode a wave that began to build in late February, but dealers were clear that this was a significant jump. Despite all of the uncertainties of 2020, dollar-yen traded in a tight range of between ¥103 and ¥106 for most of the year.

The next big challenge for investors could be an imminent test of ¥110 — a level that foreign exchange analysts say would be likely to trigger hedging strategies used by corporate Japan, potentially raising volatility.

Fundamentally, said Yujiro Goto, Nomura FX strategist, the main factors behind the dollar’s rise against the yen are US-based: positive signals on the US economy and an accelerating vaccination rollout contrast with more pessimistic signals from Japan and the expectation that there will be no change in central bank policy on interest rates.

“Japan factors, including the Bank of Japan, explain just 25 per cent of the moves in dollar-yen since January,” said Goto. 

Nevertheless, currency analysts do expect some short-term volatility this week ahead of the BoJ’s monetary policy meeting on Thursday and Friday that Deutsche Bank analysts have dubbed the “most awaited and least predictable” policy meeting since the introduction of its yield curve control (YCC) policy in 2016.

The weaker yen, say economists, could provide the central bank with an opportunity to expand its tolerance band around the 10-year Japanese government bond, which it currently sets at “around zero”. Leo Lewis

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