Risks to the Long End of the Treasury Market

The potential non-inflationary growth rate of the US economy may be stronger than expected, after Friday's January Employment Report.  And, foreign economic growth still looks to have slowed.  But, the long end of the Treasury market risks facing inflation issues from commodity prices.   The latter already have begun to climb in response to the Fed's aggressive shift away from tightening and the return of Chinese purchases.

A steeper Treasury curve could weigh on stocks at some point, as it could prompt market talk of a resumption of Fed tightening in H219.  The steeper curve would probably be interpreted as predicting stronger growth and higher inflation ahead.  Even without an increase in inflation, stronger trend growth should result in a higher level of interest rates.

There are some countervailing arguments near term.  A Brexit crisis that impacts the European markets and FX would likely depress commodity prices and Treasury yields, but presumably this would be only temporary.

Another argument is that  an end of the Fed's balance sheet reduction would prevent the Treasury curve from steepening.  Some market observers have downplayed the immediate impact of the Fed's intention of ending its balance sheet reduction sooner than expected.  They point out that the Fed has not yet stopped selling assets.  They argue the markets will be impacted when the Fed actually begins pulling back from balance sheet reduction.

The Fed's own analysis when QE began suggests these observers are wrong.  The analysis showed that the announcement of the total amount of QE was more important for the markets than the monthly pace of purchases.  In other words, the "stock" of announced QE was more important than the actual "flow."  So, the market impact of last week's FOMC Statement and Powell's testimony regarding balance sheet reduction essentially should be already built in.