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Yellen’s Fed sends wake-up call to bond market

“If they’ve managed to sleep through the night, bonds traders in the US will have quite a shock when they check their screens in the morning,” Mohamed El-Erian, chief economic adviser at Allianz, tweeted early on Thursday.

Wall Street bond traders and investors will have turned in on Wednesday night already jolted by the Federal Reserve, which under Janet Yellen’s leadership has become synonymous with caution on interest rates, delivering a more aggressive path for borrowing costs in 2017 than most expected.

The entrenched complacency in the $13tn bond market about the US central bank’s likely message was clear in the reaction that followed. Less than 24 hours after the Fed unveiled its projections for where its key short-term rate will be over the next three years and Ms Yellen gave her press conference, the yield on the policy sensitive two-year note surged from 1.16 per cent to 1.30 per cent — its highest level since 2009.

The pain administered by Ms Yellen is not the first dose the bond market has had to swallow of late. Donald Trump’s shock US election victory in early November helped vanquish a historic rally in sovereign bonds, as investors bought into the property mogul’s promise to get the US economy humming. Yesterday’s Fed surprise was that officials’ upward revision to their projected path for interest rates appeared to reflect some sense that the combination of Mr Trump and a Republican-controlled Congress will be able to cut taxes and ease fiscal policy.

“The surprise and what the market is reacting to is that most people expected a wait-and-see stance from the [Fed] in terms of how they would consider the impact of Trumponomics in the year ahead,” says Ian Lyngen, a strategist with BMO Capital Markets.

A widely anticipated rise in the federal funds rate to between 0.5 and 0.75 per cent — only the second from the central bank since the financial crisis — was overshadowed by the Fed rate setters forecasting three rises next year. That was up from a September meeting when their dot plot — which charts where individual policymakers think the Fed funds rate will end the next three years — had pencilled in just two. They also lifted their long-term view of where rates will find equilibrium.

“We have opened the door” to a faster tightening cycle, says Scott Minerd, chief investment officer of Guggenheim Investments. “If the data continue to come in how we expect, the Fed will have to move faster than people were expecting.”

In sharp contrast to most of the year, investors now also appear to be taking the Fed’s intention to raise rates multiples times in 2017 more seriously. Interest rate futures are pricing in almost three quarter-point rate increases by the end of next year.

“The bond market was negatively surprised by the Fed rhetoric and the upward revisions of the ‘dots’,” says Markus Allenspach, head of fixed income research at Julius Baer.

Given the uncertainty surrounding Mr Trump’s plan to boost government spending and reduce both corporate and personal income tax, some investors had anticipated a far more cautious tone from the Fed and no change in the trajectory of future increases. However, a return of momentum in the US economy that began before the election emboldened policymakers, with Ms Yellen saying she expected progress to continue.

The sell-off in the bond market was not just confined to sovereigns, with knock-on effects rippling out to investment-grade corporate bonds and emerging market debt.

The yield on the 10-year Treasury rose above 2.60 per cent on Thursday, its highest since September 2014. The five-year note yield has surpassed 2 per cent for the first time since May 2011.

“We’re on our way to a 2.75 per cent [yielding] 10-year,” says Rick Rieder, BlackRock’s chief investment officer of fixed income. “I don’t subscribe to the thesis we’re moving to much higher interest rates, but it will be pretty hard until we get other information from the Fed for interest rates to do anything other than drift higher.”

US bonds had already been under pressure as investors prepare for faster economic growth and a more aggressive Fed, as well as with the concern that deficits could be funded with a spurt of new Treasury issuance.

However, the more hawkish message from the Fed did not convince everyone. Doubters pointed to the very modest increase in its growth forecasts for next year and the lack of change in its inflation forecasts for 2017 to 2019. Officials on the Fed’s Open Market Committee (FOMC), for example, edge up their GDP forecast for 2017 to 2.1 per cent from 2 per cent.

Richard Clarida, a global strategic adviser at Pimco, says he is puzzled by the Fed’s higher rate forecast profile for next year: “In sum, four members of the FOMC appeared willing to place at least a modest bet that Trumponomics will justify three hikes instead of two in 2017.”

That was echoed by Philip Marey, strategist at Dutch lender Rabobank, who says he was “sceptical of three hikes in 2017”, pointing to the lag in any impact on growth and inflation from an expected infrastructure stimulus from Mr Trump, as well as shift in members of the FOMC voting members next year.

While bonds retreated, the dollar surged in the wake of the Fed and that may also shape as a restraining factor on Fed tightening next year.

With the euro and yen under further pressure, the dollar index stands at its highest level since 2003. The dollar’s performance reflects the accelerating divergence between US and global rates, with the attraction of higher yields on Treasuries drawing capital to the country.

“The US dollar may have been ahead of the Fed in digesting what the US election result might mean for growth, but it will still likely strengthen further on the Fed’s swifter than expected conversion to a possible fiscal reflation theme,” cautioned Daragh Maher, a currency strategist at HSBC.

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