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Fed ‘Third Mandate’ Forces Bond Traders to Rethink Age-Old Rules

(Bloomberg) -- For generations on Wall Street, it was a statement of fact: The Federal Reserve’s “dual mandate” of price stability and maximum employment governed how it set interest rates, invoked time and again from Alan Greenspan to Jerome Powell.

So when Donald Trump’s latest pick for Fed governor, Stephen Miran, cited a third mandate — that it must also pursue “moderate long-term interest rates,” chatter lit up on bond trading desks as analysts debated what it all meant.

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To the surprise of many, it turns out that Miran was simply quoting a long-forgotten part of the Fed’s statute in full. But for market veterans like Andrew Brenner, the import for financial markets was clear — and alarming, with the potential to upend portfolios.

As Brenner sees it, the fact that Miran, of “Mar-a-Lago Accord” fame and a newly minted Fed official, saw fit to mention the “third mandate” in congressional testimony is one of the clearest signs yet that the administration intends to wield monetary policy to influence longer-term bond yields, using the central bank’s own bylaws as cover.

It also underscores how willing Trump is to upend decades of institutional norms to break down the Fed’s longstanding independence in service of his own goals.

The Trump administration “found this clause in the original Fed documents, which were not well defined, that allow the Fed to have much stronger influence over long rates,” Brenner, vice chairman at Natalliance Securities LLC, wrote in a Sept. 5 note. “This is not today’s trade, but certainly something to think about.”

No such policies are in effect now, and they haven’t been needed lately, with US yields of all maturities falling toward their lows of the year as a deteriorating labor market paves the way for fresh Fed rate cuts. Moreover, in recent times the “third mandate” was considered more of a natural byproduct of managing inflation.

Still, some investors say the hyperfocus on long-term rates is enough for them to include the possibility of some type of action in their bond-market calculus. Others warn that the extent to which unorthodox maneuvers to cap long-end rates become part of policy, it raises the risk of adverse effects, particularly inflation, that would make debt management — and the Fed’s job — even harder in the end.

While the rate-setting process around the Fed’s short-term target often takes the spotlight, it is longer-dated Treasury yields — set in real-time by traders around the world — that largely determine what Americans pay for trillions of dollars of mortgages, business loans and other debts.

The importance of long-dated rates for the US economy and the cost of home ownership has been regularly highlighted by Treasury Secretary Scott Bessent, who like Miran invoked the Fed’s three statutory objectives in a recent opinion piece in the Wall Street Journal that railed against mission creep at the central bank.

“This is clearly a priority,” as the administration wants to stimulate the housing market, Lisa Hornby, head of US fixed income at Schroders, said on Bloomberg Television.

A potential trigger-point for action would be a scenario where long-term yields stay elevated despite a series of Fed rate cuts, says George Catrambone, head of fixed income at DWS Americas.

“Whether it comes from the Treasury, and/or supported from the Fed or vice versa, they will get there one way or another, that reaction function will occur,” Catrambone said. In recent months, he has been rolling over maturing shorter-dated Treasuries into 10-, 20- and 30-year securities, and admits “it has been an out-of-consensus stance.”

Among the possibilities being floated in the bond market that could help bring down or at least cap longer-dated rates include the Treasury selling even more US bills and ramping up buybacks of longer-dated bonds. A bigger step would involve the central bank buying bonds as part of quantitative easing, though Bessent has written at length about what he argues are negative effects from past Fed QE. The Treasury chief has, though, backed QE for “true emergencies.” Another option would be the Treasury working with the Fed’s balance sheet to absorb longer-dated issuance.

However remote now, the prospect of the ultimate buyer stepping in to cap rates increases the risk, at least on the margin, of betting against the long end.

“If a less independent Fed decides to get QE going again, you’d get hurt a lot on the curve or if Treasury were to be much more aggressive with yield-curve management,” said Daniel Ivascyn, Pacific Investment Management Co.’s chief investment officer. The bond giant remains underweight on longer-end debt, though it has been taking profits on positions aimed at profiting from outperformance by shorter-term securities, which have been very good for their top-performing funds this year.

‘Reasons Don’t Apply’

A push from Washington to bring down long-dated interest rates would repeat prior episodes, notably during and after World War II. In the early 1960’s, the Fed launched “Operation Twist,” an initiative that sought lower long rates while keeping shorter maturities steady.

During the depths of the global financial crisis, the Fed began large-scale asset purchases of mortgages that soon included Treasuries, in an effort to bring down long-dated yields and stimulate the economy. By 2011, the Fed launched another version of the twist. These early rounds of quantitative easing would be dwarfed by the scale of bond purchases seen during the Covid era, that saw the Fed buying corporate credit.

“Yes, in the past, the Fed has done what Trump is trying to do, and Congress has allowed the Fed to do this,” but it’s chiefly been during wartime or economic distress, said Gary Richardson, an economics professor and Fed historian at University of California, Irvine. “Those reasons don’t apply now. We’re not in a major war. We are not in a huge great depression. Now, it’s like Trump wants to do this.”

The risk of a more active Treasury and Fed trying to muscle longer-dated rates lower could backfire, especially when inflation remains sticky and running above target, as the likes of Carlye Group and others warn. The prospect of the Trump administration goosing the economy with more stimulus helped drive 10-year yields to this year’s peak of 4.8% in January.

More broadly, there is the question of just how to define “moderate long-term interest rates.” By historical standards, the current level of 10-year US yields near 4%, and even at their earlier high this year, are well below an average of 5.8% dating back to the early 1960s, according to data compiled by Bloomberg. If anything, that would argue against the need for any unusual policy moves.

“It’s hard for me to say what moderate means in a number, but this is a little bit of Goldilocks here,” said Mark Spindel, chief investment officer at Potomac River Capital, who co-wrote a book with Sarah Binder titled . “We’re not too high, we’re not too low.”

For Spindel, the ambiguity of the phrasing around moderate long-term rates means it could be used to “justify almost anything.” He said he’s buying short-dated Treasury inflation-protected securities, or Tips, as a hedge against the risk of the Fed losing independence, “owning inflation insurance” in case the Fed becomes political.

As government deficits balloon, lower rates across the curve would reduce the cost of financing the growing burden, with the US national debt at $37.4 trillion as of Sept. 9, according to data compiled by Bloomberg. The passing of the latest budget that extends the Trump tax cuts is expected to keep the US budget deficit running at an elevated pace of more than 6% gross domestic product.

Bessent has emulated his predecessor, Janet Yellen, and sought to boost sales of short term bills and hold the size of long-dated sales steady, while stating it is not optimal for tax payers to sell long bonds at current yields.

“The debt and debt servicing costs are a constraint on the government and they have to do something about it and they can’t do it at the fiscal level,” says Vineer Bhansali, founder of the Newport Beach, California-based asset-management firm LongTail Alpha. “So they have to do it at the Fed level because that’s the only game in town. And so long rates being manipulated down by the Treasury secretary is par for the course now.”

And for those worried about inflation burning faster, that’s a risk the administration seems willing to take, said Bhansali. “The Fed ultimately will have to do what the president and the fiscal authorities want — higher inflation be damned,” he said.

--With assistance from Alexandra Harris and Ben Holland.