The Federal Reserve building is set against a blue sky in Washington, U.S., May 1, 2020. REUTERS/Kevin Lamarque/File Photo
NEW YORK, July 31 (Reuters) - A sharp shift towards a steeper U.S. Treasury bond curve following the Federal Reserve's decision to leave interest rates unchanged this week has raised concerns about the central bank's credibility and willingness to fully confront inflation.
The drop in front-end yields, even as those on longer tenors climbed, suggests growing skepticism the Fed will raise rates again, analysts said, despite Chair Kevin Warsh's insistence on Wednesday that policymakers "will not hesitate to act" if price pressures fail to ease.
After the Fed left rates steady, despite three officials dissenting in favor of a hike, Treasury yields initially fell across maturities as investors welcomed the absence of an immediate rate increase.
That reaction quickly gave way to a more striking pattern. Yields on shorter-dated Treasuries continued to decline while those on longer-dated notes and bonds surged, particularly at the 30-year end of the curve, which soared to its highest in 19 years. The result was a pronounced steepening of the yield curve that some investors interpreted as a sign markets are losing confidence in the Fed's commitment to fight inflation.
Zachary Griffiths, head of macro and investment grade strategy at CreditSights, described the move as a "twist steepener" and "an unhealthy response" to the Fed's policy decision.
The steepening persisted on Thursday, widening the gap between short- and long-dated yields across both the 2-year/10-year and 2-year/30-year segments of the curve.
MARKET QUESTIONS FED RESOLVE
"The twist in the curve tells you that the market thinks the Fed is not about to launch an aggressive rate hike cycle," said Chip Hughey, managing director of fixed income at Truist Wealth.
"That may be potentially good for growth, but it injects more uncertainty into the Fed's fight against inflation."
One explanation for the Fed's decision to stand pat, analysts said, is that financial conditions have already tightened significantly without any additional action from policymakers.
Fed Chair Warsh argued that markets have effectively done much of the work themselves, pushing both nominal and inflation-adjusted Treasury yields higher as investors respond directly to incoming economic data rather than relying on Fed guidance.
So far in July, 10-year yields have climbed 25 basis points, the largest one-month rise since March.
YIELD CURVE DYNAMICS
Yield-curve steepening typically indicates that markets are pricing in cuts or no further hikes.
In a traditional "bear steepener", yields rise, with those on the long end increasing faster than shorter-dated notes. This time, however, short-term yields fell, while long-term bonds rose further, producing an unusual divergence in rate expectations.
Analysts said the move also reflected an unwinding of aggressive bets that the Fed would fight inflation by either raising rates in July or signalling additional tightening is imminent after Middle East tensions escalated this month.
Markets had fully priced in roughly 25 basis points of tightening by September, while the spread between 2-year and 10-year yields flattened, sliding 5 basis points the week before the meeting.
Guneet Dhingra, head of U.S. rates strategy at BNP Paribas, said the steeper curve suggested much of the inflation-fighting credibility the Fed gained after its June meeting had now been lost. Without a clear signal that rate increases remain on the table, he said, that credibility could erode further.
"The market was disoriented by this new Fed approach of providing less guidance," said Nicolò Bocchin, global co-head of fixed income at Azimut Group. That, he said, meant investors were concerned about inflation and pricing it into long-end bonds.
Next week's July nonfarm payrolls report could provide a critical test of that view.
CreditSights' Griffiths said if next week's employment data is stronger than expected, that may reinforce concerns the Fed should have raised rates this week and accentuate the curve steepening. A weaker report, however, could trigger a sharp reversal by easing fears the Fed is falling behind the inflation curve.
Reporting by Gertrude Chavez-Dreyfuss Editing by Vidya Ranganathan and Louise Heavens
Our Standards: