Seeing it all come together: bonds, the yield curve and the end of the Fed's taper
For two years the Fed was the whale in the bond pool. On 9 March 2022 it climbed out, and the water level did what water levels do.
Sometimes weeks happen in a day. In the third week of March 2022 the bond market did in ten days what it would ordinarily take a year to do, and the reason was not a mystery. On 9 March the Federal Reserve made the last purchase of the programme of quantitative easing it had begun two years earlier. From that day the largest buyer in the Treasury market was no longer buying. This page keeps the mechanics as they were set out at the time, because the argument was made before the move and the move confirmed it.
The whale in the pool
The thesis was simple enough to fit in a sentence. For two years the Fed had been buying Treasuries at every maturity in quantities that let it decide, in effect, what the yield curve would look like. Call it yield-curve control by purchase rather than by decree. A curve set by its own reader cannot signal anything: it could not show the inflation that was building through 2021 and it could not show a recession, because the Fed was holding both ends.
The image used here was a whale so large it filled the whole pool. While it lay there the water level, bond prices, stayed high and yields stayed low, whatever the weather. The moment it climbed out, the level would fall, quickly, to wherever the weather said it should be. Falling prices are rising yields. The prediction was that when the taper ended the “bond vigilantes”, the investors who sell government debt when they think inflation is being under-priced, would come out of the woodwork and reprice the whole curve in weeks.
What happened in the first fortnight
The ten-year yield stood at 1.95 per cent on 9 March. By 23 March it was 2.39, a move of 44 basis points that in the years of the whale would have taken a season. The two-year moved faster still, which is what flattening means: short yields rising toward long yields as the market prices in Fed rate increases. The gap between two- and ten-year yields, the Fed’s own favourite gauge, shrank toward zero at a speed strategists on several desks called ominous. One derivatives strategist put it plainly: the yield curve looked ominous, and the bond vigilantes were coming out of the woodwork.
Globally, a Bloomberg index of investment-grade bonds had fallen more than 11 per cent from its peak, the largest drawdown in data going back to 1990, surpassing the 10.8 per cent fall of 2008. The Financial Times described Treasuries as returning to normal after “a policy-induced economic coma” during the pandemic. That was the same word used here, months earlier, for the same condition.
Why it mattered beyond bonds
A flat and then inverted curve does not cause recessions. It is a sign the Fed itself regards as its most reliable, and it changes the price of everything that is priced off Treasuries: mortgages, corporate debt, the discount rate applied to equities. The argument made here was that because the curve had been held down artificially, it would show the recession late rather than early, after the downturn had already begun rather than nine months before it. That is why the probability of a recession starting in the first quarter of 2022 was put at 95 per cent on this page in March, while the most bearish banks were still talking about 2023.
The same week, the president told the Business Roundtable that the world was “at an inflection point” that “occurs every three or four generations”, and that “there’s going to be a new world order out there, and we’ve got to lead it”. The remark was made about the war and the sanctions. It was read here as confirmation that the arrangements of the previous thirty years, in trade and in money, were being redrawn, and that a bond market pricing in a new inflation regime was part of the same story.
What the record shows since
The two-year yield rose above the ten-year at the end of March 2022, then decisively in July, and the curve stayed inverted for more than two years, the longest inversion in the modern record. The Fed raised its policy rate from near zero to above 5 per cent by mid-2023. First-quarter GDP did contract, as the following page records, but the NBER never dated a recession. The mechanics described here held: the curve moved fast once released, and it moved in the direction predicted. What it predicted, this time, took longer to arrive than any previous inversion, and the argument over whether it arrived at all is still open.