This week will likely become one of the heaviest in terms of Fedspeak this year. Powell spoke yesterday and his opening remarks before the main speech today made it clear that in the current recovery, the Central Bank will behave differently. Acknowledging the fact of a recovery gathering speed, the Fed prefers to prepare for the worst possible outcomes, as covid introduces a lot of uncertainty, which is sometimes impossible to quantify, so the cost of mistakes are high.
Hence the desire to maintain ultra-easy monetary policy for a relatively long time by historical standards. It is necessary to ensure that the high unpredictability of the future is reduced, which takes time.
The debt market realizes that the Fed will tolerate an increase in market rates, so pullback in long-term yields that we are witnessing this week is most likely temporary. The short-term oversold led to purely technical buy signals: an ETF that invests in Treasuries with a maturity of 20+ years fell last week at its fastest rate in several decades, as seen from the extreme decline in the weekly RSI:
In the absence of serious economic shocks that will undermine current expansion trend, inflation concerns in the US will likely drive further steepening of the yield curve, i.e., demand for longer-maturity Treasuries will ease while demand for shorter-dated bonds will remain strong. That will be a factor of support for USD as bonds sell-off leads to corresponding increase in for cash.
Nonetheless, anxiety about short-term prospects for recovery appears to be on the rise. Germany extends lockdowns and the growth outlook for the European economy in Q2 worsened, which led to sell-off in risk assets and pronounced spike in demand for fixed-income assets. Bund yields tumbled on Tuesday along with the slack in equities and oil rout. The bout of risk-off led to outflow of US investors from international asset markets, fueling demand for USD. In addition, the concerns of the ECB about higher market rates, which were felt in the CB’s decision to increase asset purchases in the PEPP, was the same time as an acknowledgement that the economy can’t sustain higher rates as growth outlook worsens.
Oil decline should ease inflation concerns for some time as commodity prices inflation is a key driver of cost-push inflation. Hence, we may see some prolonged retreat in bond yields in the US which should ease pressure on equity markets and spur more upside in the near term.
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