Fed meeting may test low U.S. Treasury yields

By Karen Pierog

CHICAGO (Reuters) - The $22 trillion market for U.S. Treasury securities may get a reality check from the Federal Reserve this week following a plunge in interest rates that bucked expectations of higher yields this year as the economy rebounds from the COVID-19 pandemic.

Yields, which move inversely to prices, have been in a downward trend since the last Federal Open Market Committee meeting in June. The market initially perceived the Fed as being a bit hawkish as policymakers last month projected an accelerated timetable for rate hikes and opened discussions on ending crisis-era bond purchases amid a backdrop of rising inflation.

But the benchmark 10-year note yield, which rose as high as 1.776% in late March, fell to its lowest level since February on Tuesday at 1.1280%. It, along with the 30-year bond yield, were trading about 30 basis points lower on Friday than where they were just after the meeting.

The yield curve has also flattened since then, with the gap between two- and 10-year notes shrinking to its smallest level since February.

The FOMC meets on Tuesday and Wednesday. George Goncalves, head of U.S. macro strategy at MUFG, said the central bank needs to push back a bit against the market and stick with an optimistic outlook that shows the economy has a "decent runway" and that the central bank still intends to taper its $120 billion in monthly debt purchases.

"That's the right message and the positive spin that the Fed can deliver next week, which would then stop these unabated, nonstop rallies," he said.

Morgan Stanley (NYSE:MS) strategists also believe the meeting could be an important catalyst for pushing yields higher.

"An upbeat assessment of the economy from the Fed and continued discussion of tapering could ring hawkish to the market," they wrote in a U.S. Economics & Global Macro Strategy report on Thursday.

They noted that the market's reaction since the June meeting was due to technical factors like the unwinding of bets that the yield curve would steepen and position squaring, exacerbated by concerns over the Delta variant of the coronavirus and a slowdown in economic growth.

While the FOMC's June meeting statement "implicitly declared victory" on the COVID-19 front, the spread of the Delta variant and slowdown in vaccinations may change the Fed's tune this month, according to analysts at Jefferies (NYSE:JEF).

"If anything, the tone of the FOMC statement and the press conference is likely to be incrementally more dovish than the June meeting given the renewed health concerns," they said in a recent report.

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Kathy Bostjancic, chief U.S. financial economist at Oxford Economics, said data will have to drive the market, which may have swung from being too exuberant about growth expectations to too negative now.

"As (Fed Chair Jerome) Powell said, it's going to take a good six months to really know on the inflation front how much of this is transitory," she said. "And I think we'll learn a lot more over the second half of this year too in terms of the staying power of the economy."