The late-year selloff in the bond market has begun to look overextended. Recent trading pushed 10-year yields back down to 4.56% on Jan. 17 after reaching as high as 4.8%.
The sudden shift in the market coincided with the growing sentiment that the Federal Reserve will cut the overnight policy rate by only 50 basis points this year.
This change in sentiment is in response to sticky inflation and the risk that new policies on trade and spending will put additional upward pressure on prices.
A look at the MOVE index, which tracks volatility in Treasury securities, shows that the bond market is looking for a new center of gravity as interest rates normalize and as the regime change in monetary policy and economic growth sets in.
After a decade of cheap money, we think that the center of gravity for the 10-year Treasury note is now roughly 4.5%, with a trading range of 4% to 5%. We think this implies that bond market volatility will return to its long-term average level.
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In addition, the Federal Reserve’s data-dependent approach to monetary policy, which relies on preceding economic reports, is in the process of being overtaken by events.
The prospect of changes to fiscal policy, which is behind the recent volatility in fixed income markets, requires the Fed to shift toward a more forward-looking strategy.
It is time for the Fed to drop its over-emphasis on data dependency and move to a more strategic view that takes into account the risks to the outlook that will be front and center this year and next.
Without such a shift, volatility in the bond market will continue to be excessive, which would only restrain fixed business investment and growth.
