The Fed is worried about another 'taper tantrum'
On Wednesday, it released the Minutes of its latest policy meeting held at the end of April, which re-iterated that it will be fully data-dependent and indicated that a rate hike in June is unlikely.
Additionally, the Minutes noted a concern about a spike in term premiums, or the compensation required by investors for holding long-term bonds instead of short-term notes. If the risk of holding long-term bonds increases due to the expectation for higher future rates, yields would spike as term premiums increase.
Here's the key section from the Minutes:
"In their discussion of financial market developments and financial stability issues, policymakers highlighted possible risks related to the low level of term premiums. Some participants noted the possibility that, at the time when the Committee decides to begin policy firming, term premiums could rise sharply--in a manner similar to the increase observed in the spring and summer of 2013--which might drive longer-term interest rates higher."
That period in 2013, of course, was the so-called "taper tantrum."
Yields spiked after then chairman Ben Bernanke first indicated that the Fed would begin reducing its bond buying program. The yield on the benchmark 10-year note jumped from near 1.6% to about 3% within three months in the late spring of 2013, an event the Fed is hoping to avoid a repeat of.
And as they've noted in past discussions of bond market structure, the Fed wants to avoid this action so as to not create a messy run for the exits from investors:
"In this connection, it was suggested that the tendency for bond prices to exhibit volatility may be greater than it had been in the past, in view of the increased role of high-frequency traders, decreased inventories of bonds held by broker-dealers, and elevated assets of bond funds. A couple of participants underscored the need for a better understanding of the structure of the bond market in the current environment, including the effect on bond market behavior of regulatory changes."
The Fed also knows that high-frequency trading aside, the way it communicates its first rate hike in several years will be key to how the bond market reacts (and we know it has recently struggled with its language):
"Some participants noted that careful Committee communications regarding its policy intentions could help damp any resulting increase in market volatility around the time of the commencement of normalization."