Here’s the FT:
A steady decline in yields since the start of the second quarter accelerated sharply this month, which market participants attributed to a liquidation of short positions by hedge funds and other momentum-orientated traders whose bets had turned against them. . . .
“The market was banking on a dovish contingency at the Fed,” Tipp said, who would allow the economy to run hot, pushing up inflation and reducing the value of long-dated bonds. That narrative stalled last month, he said, when Fed officials opened the door to raising rates in 2023, earlier than previously expected.
Mark Lindbloom, who manages the Western Asset core plus bond fund echoed that view. “We do not believe the Fed today, or in the future will sacrifice its credibility” from taming inflation in the 1980s, he said.
It seems like some bond traders had assumed that AIT was being used by the Fed as an excuse to engage in a more dovish monetary policy. Then, some recent statements by Fed officials convinced the market that the Fed is serious about keeping inflation close to 2% on average. Inflation expectations fell and this dragged down long-term bond yields.
In my view, there are still two unexplained mysteries:
1. While there are cases where a contractionary policy announcement immediately reduces bond yields, in other cases the effect seems to be delayed. Why is that?
2. What explains the long run downward trend in real interest rates? It’s clearly not (easy) central bank policy, as we’ve seen that tighter money actually reduces interest rates. So what is it?
Given point #2, the Fed needs to fix its monetary policy. While the adoption of AIT is a step in the right direction, a further step is needed. I see two primary options. First, raise the inflation target to 3%. Realistically, that’s not going to happen. Second, acquire a more powerful tool kit (a subject on which I’ve written extensively). Given the gridlock in DC, that probably won’t happen either, even though each party would probably support the idea at a time when they were in power. A couple years ago, I suggested that the Fed was missing a golden opportunity to ask for more powerful tools when Trump was in power. Now it’s too late.