Federal Reserve Chairman Jerome Powell speaks during a Senate Banking Committee hearing on Capitol Hill in Washington on December 1, 2020.

Al Drago | Pool | Reuters

Rising bond yields and the accompanying fears of inflation make the appearance of Federal Reserve Chairman Jerome Powell this week before Congress dramatic.

The central bank chairman is scheduled to address the Senate and House bodies on consecutive days as part of the mandatory biannual monetary policy updates.

Usually, routine matters, the recent financial market turmoil and concerns about how the Fed might react have led investors to pay a little more attention than usual to the Tuesday and Wednesday hearings.

“This is one of the more interesting episodes a Fed chairman had to testify in,” said Nathan Sheets, chief economist at PGIM Fixed Income. “Sometimes we say, ‘ho hum, no news.’ This is going to be news. He’s really caught between a rock and a hard place. “

What has caught the market’s attention lately has been a pickup in government bond yields, especially further out on the curve.

While the 2-year ratio remains unchanged for 2021, the 5-year ratio was up nearly a quarter percentage point at the close of trading on Friday, while the yield on the 10-year benchmark note rose 41 basis points to 1.34% , an area where it hasn’t been since around the same time in 2020, before the worst pandemic broke out.

The 30-year bond yield has risen even further, rising nearly half a point to 2.14% this year.

Powell’s dilemma is this: Rising bond yields could signal the reflation of the economy that drove the Fed, so they are higher for good reasons. However, should the trend get out of hand, the Fed may need to tighten policy faster than the market anticipated to offset some of the good that came with the yield boost.

To make matters worse, the markets may also not like it when Powell is overly complacent.

“If that testimony were behind closed doors, Jay Powell would be pretty pleased with what he sees in the economy and in the markets,” said Sheets, using the Fed chairman’s nickname. “But since it’s public, he has to be careful. If he’s overconfident about the rate hike, the markets will see this as a significant green light to higher rates.”

“The Fed is happy with an organic rate hike, which is reflected in different views on growth and inflation,” he added. “But I think the Fed also wants to be careful not to create and reinforce self-sustaining dynamics that raise interest rates for other reasons.”

These “other reasons” would primarily be fears that the economy could overheat.

Stimulus and more stimulus

The Fed pursued a historically loose policy over the past year, cutting its base rate to near zero and buying bonds worth at least $ 120 billion every month. This is on top of a number of lending and liquidity programs that have expired since then that were implemented in the early days of the Covid-19 crisis.

At the same time, Congress has received more than $ 3 trillion in fiscal stimulus and could approve up to $ 1.9 trillion more by the end of the week.

Everything that has happened in an economy that, in addition to a still problematic employment problem, especially in the service sector, is a buzz. Wall Street picks up growth expectations for the first quarter and market-based inflation indicators are rising.

Powell’s tightrope walk will be all the more convincing this week.

“The market sentiment has changed,” said Mohamed El-Erian, Allianz’s chief economic advisor, in CNBC’s “Squawk Box” on Monday. It is no longer a question of whether the returns will increase, but of when the step is too big. The market is trying to find out. “

Investors are particularly concerned about whether all stimuli will not go overboard and threaten to destabilize the economy in the long term.

“I can predict that because of the Fed, the yellow lights will be blinking all over the Fed [yields] Movement and steepness of the yield curve and the Fed could do more to try to control yields, “said El-Erian.

Fed officials have largely rejected so-called yield curve control in order to use their purchasing power on bonds to control interest rates between different maturities.

But the market could force the hand of the Fed, and Powell is likely to be asked where he stands and what instruments the Fed has to calm market problems. He has repeatedly stressed that the central bank has the weapons to control inflation, but there is a price to be paid to using those weapons. Markets used to low yields and companies used to cheap borrowing costs could be shaken by an unexpected move by the Fed.

Evidence of how closely the market is watching the issue came Monday morning when European Central Bank President Christine Lagarde said she was “closely monitoring longer-term nominal bond yields”. Her words were enough to calm a nervous market and turn the opening loss on Wall Street into a mixed market with the Dow trading in the early afternoon. Government bond yields were largely unchanged for the day.

Tom Lee, Managing Partner and Head of Research at Fundstrat Global Advisors, noted that “clients have already raised some concerns about this week. Part of that reflects the fact that bond yields have been rising steadily and equity investors are nervous that the.” Bond market could hit some sort of “break point” during Powell’s testimony.

Powell speaks to the Senate Finance Committee Tuesday and the House Financial Services Committee Wednesday.