Pub. 12 2021 Issue 3

wvbankers.org 22 West Virginia Banker Bond Market Behavior: Trusting the Fed on Inf lation T he narrative for the U.S. economy has shifted as we move into the second half of this year. Not long ago, financial markets were saturated with talk about inflation and rising interest rates. However, after an initial economic reopening and rebooting surge, the bond market is now telegraphing expectations for weaker growth, lessened inflation fears, and perhaps a more diligent Federal Reserve. The 10-year U.S. Treasury yield, which had jumped sharply from the August 2020 low-point of .50% up to 1.75% through the end of the first quarter, reversed and steadily traded lower into mid-year, ending the second quarter below 1.50%. The slope of the yield curve, which had previously steepened to the widest in six years, is now much flatter, reflecting clarity from policymakers and diminishing expectations for sharply higher yields. Whereas fear of sustained inflation was a continuous theme for much of the first two quarters, concerns about growth constraints and adjustments to monetary policy are now prevalent. The jump in inflation seen so far this year has been tagged “transitory” by the Fed. And though they get a lot of things wrong, they seem to have a reasonably good handle on this as market measures of inflation expectations fell 25-30 basis points during the second quarter. The dampening of inflation fears is partly due to the continued reopening of global trade flows and access to low-cost resources, along with repaired supply chains and cost-saving efficiencies that accelerated during the pandemic shutdown. But a key reason for the shift in market sentiment is belief in the Fed’s commitment to stamp out any inflation fire should By Jeffrey F. Caughron, The Baker Group