The dollar retreated and a key portion of the US government bond market flashed inflation warning signs amid concern that the Federal Reserve’s new policy framework could erode the appeal of US assets.
Fed chair Jay Powell on Thursday revealed enhanced flexibility to allow the inflation rate to push past the central bank’s 2 per cent target.
The tweak is designed to allow more leeway to support the economy in the wake of the coronavirus shock. But for markets, it probably means lower benchmark interest rates for longer and a potential pick-up in long dormant inflation.
Jan Hatzius, chief US economist at Goldman Sachs, described the Fed’s new framework as “a significant dovish long-term shift”.
The dollar index, a measure of the currency against six developed market peers, fell 0.8 per cent on Friday as investors weighed up the move. Sterling rallied to $1.33, its highest level of 2020, while the euro advanced to $1.1914. MSCI’s measure of emerging market currencies rallied to its highest level since early March in a sign of the buck’s broad decline.
US stocks were modestly higher, with the S&P 500 up 0.2 per cent and headed for its seventh day of gains and the tech-heavy Nasdaq Composite up 0.6 per cent. European stock markets, by contrast, weakened across the board.
Bond-market shifts that began after Mr Powell’s speech on Thursday continued into Friday. Longer-term Treasuries endured further selling, pushing the yields on those assets higher, while debt with shorter maturities gained in price, knocking those yields lower.
With the Fed having unleashed a barrage of stimulus measures to shore up the economy, some investors have grown worried about inflation running too hot in the future — a perennial risk to long-term investors in bonds and other assets such as dividend paying stocks because it eats away at their returns.
Wall Street economists do not expect the type of runaway inflation witnessed in the 1970s. However, with interest rates at historic lows, it takes only a modest rise in prices to wipe out sizeable portions of bond returns.
“Be careful what you wish for,” said David Kelly, chief global market strategist of JPMorgan Asset Management. “There is a risk that overall inflation will overshoot [the central bank’s] target and they won’t have the political will to pull in the reins before it becomes a problem.”
This concern is reflected in the widening gap between yields on five-year and 30-year Treasuries. The spread reached 1.23 percentage points on Friday, the highest level since 2016, according to Refinitiv.
The US 10-year break-even rate, an important measure of market-based inflation expectations for the next decade, reached 1.73 per cent on Thursday, rebounding from a low of 0.5 per cent in March, data from the St Louis Fed show.
The rate is now essentially where it started 2020, but that masks a larger shift. The 10-year Treasury yield is far lower at 0.74 per cent compared with 1.91 per cent at the end of last year. That means market expectations for returns after inflation have weakened markedly.
These depressed real yields have been a key factor pressuring the dollar index, which is down 4.3 per cent this year.
Chris Turner, strategist at ING, said the Fed signalling it would let inflation run hotter during a time when rates were low would be a negative for the dollar outlook for “quarters to come”.
Still, not all investors were confident that the Fed’s new aim would lead to sharp rises in price growth — a target that has proven to be out of reach since the 2008 financial crisis.
“It’s not a significant paradigm shift,” said Allison Boxer, US economist at Pimco, one of the world’s biggest money managers.
“With today’s high level of slack in the economy expected to dissipate only gradually, we think fiscal policy, not monetary policy, will be the key determinant of the Fed’s success in reaching its inflation objective over the next several years,” she added.
Ellen Zentner, US economist at Morgan Stanley, said: “While this was a historic moment for monetary policymaking, we now need to see the Fed put its money where its mouth is, that is, sustain the economic conditions necessary to generate an overshoot of its 2 per cent goal and return the labour market to pre-Covid [levels].”