Surge in US Treasury rates suggests the bond market expects the Fed to slam brakes

Ever the contrarians, US stock traders responded to the development they had dreaded for 4 years by buying stocks and sending the Dow Jones Industrial Average soaring by more than 500 points.

Stocks were initially battered by the US Federal Reserve's latest policy statement this week, which was a logical enough response. The Fed raised rates by a quarter of a percentage point, promised a whopping 6 more hikes this year and boosted its outlook for inflation, citing, in part, the impact of Russia's invasion of Ukraine.

To the Treasury market, all of this sounded like Fed chairman Jerome Powell declaring war on inflation, in a style not seen since the 1970s.

Gone was the dovish Powell with soothing statements about inflation as the "transitory" economic side effect of the Covid 19 pandemic. In his place was a new hawkish incarnation with warnings about the "need to return the economy to price stability".

Yields on the two-year and 10-year Treasury hit their highest levels since 2019 in the wake of the policy statement, an important development because of how many loans are benchmarked to those bond rates.

After years of credit costs at practically zero, banks, corporations and consumers will soon feel the turn of the screw from interest expenses once more. The average 30-year mortgage rate had plunged below 3 per cent at the depths of the pandemic. It's now around 4.5 per cent and still rising.

The surge in Treasury rates suggests that the bond market - the most attuned to central bank policy - expects the Fed to slam the brakes, even if slowing inflation means slowing economic growth.

In its 2021 guise, "the Fed seemed to be blowing through the stop signs rather than carefully testing the limits of the economy", said economists at brokerage Bank of America Global Research, who dubbed Powell's reinvention as a hawk as "the great capitulation".

If Powell's about-face is making the bond market uneasy, he still has the full confidence of the stock market. Russian President Vladimir Putin's vicious tactics, higher inflation and rising interest rates were temporarily forgotten when Powell made positive comments about the US economy.

Powell was hardly ebullient about prospects, saying that he did not see risks of a recession this year as "particularly elevated".

That reassurance might seem a flimsy basis for a nearly 4 per cent rally in the Nasdaq Composite, considering it came from the same man who was reassuring markets that inflation was nothing to worry about just a few weeks earlier.

A recession was already priced into stocks so anything else would be a pleasant surprise, said Eric Marshall, the president of mutual-fund firm Hodges Capital.

This was the sixth worst start to a year ever for the broad Standard & Poor's 500, which fell 10.6 per cent in the first 50 sessions, according to brokerage LPL Financial. The domestically focused small-cap Russell 2000 fared even worse, falling more than 20 per cent since last November, deep into bear-market territory.

Many tech stocks, including the likes of Chinese giant Alibaba, have fallen by 50 per cent or more since their peaks. The stock market had priced in "stagflation", a situation akin to the 1970s where regional conflicts cause shortages of energy and the price spikes that follow lead to prolonged recession.

That worst-case scenario could yet happen. The effects of US$100 oil and record-high wheat prices are still rippling around the world.

This is a world, after all, where German Chancellor Olaf Scholz came under domestic pressure to ban all natural gas imports from Russia, even though such a move would leave much of one of the world's largest economic powers in the dark.

There could be more darkness ahead, and a return to the 1970s lines of cars waiting to fill up on overpriced gasoline. There could well be a global recession this year.

On Wednesday, Powell's confidence that he could slow inflation without slamming the brakes on economic growth was enough for the stock market. How long that optimism can linger in the face of rising inflation and Treasury yields remains to be seen.

Much will depend on whether the Fed can convince the American consumer - and not just the stock market - that it can keep prices under control.

"No one predicted the severity of the supply side problems in the past year. These are likely creating not only a temporary inflation shock, but also lasting impacts on inflation expectations," said the Bank of America economists.