The U.S. government bond market is more volatile than it has been since the early days of the pandemic as investors wrestle with the Federal Reserve's next monetary policy moves.

On Feb. 14, the ICE BofA MOVE Index, which tracks the price movements of options on a basket of Treasurys to measure volatility in the government bond market, surged to its highest point since March 2020, when the Fed dropped rates to near zero and began buying bonds to dull the economic impact of COVID-19.

The volatility has created new hurdles for investors and corporate strategists who have long depended on the relative safety of the government bond market.

"Right now, markets are very volatile and rates this year have been moving very rapidly," said Jason England, global bonds portfolio manager at Janus Henderson Investors. "The key thing here is uncertainty … we're not sure what direction the central bank is going to go."

The recent spike in volatility is almost entirely due to questions over how quickly the Fed will hike rates and reduce its balance sheet in order to combat inflation, which continues to rise at rates not seen in roughly 40 years.

Standard or supersized?

Views on what the rate-setting Federal Open Market Committee will do when they meet in March have shifted significantly over the past month. The market sees a rate hike at that meeting as a sure thing but is split on whether the Fed will hike rates by the standard 25 basis points or opt for a "supersized" hike of 50 basis points, something that has not taken place in over two decades.

The CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market, showed market odds of a hike of 50 basis points at the March meeting of roughly 94% shortly after the U.S. Bureau of Labor Statistics reported Feb. 10 that the consumer price index jumped 7.5% year over year in January.

The minutes from the Fed's January meeting, released Feb. 16, showed no mention of a rate hike of 50 basis points and said some officials feared that "financial conditions might tighten unduly" in response to a quick tightening of monetary policy. Odds of a larger rate hike dropped about to about 45% in response.

Tantrum trap

"The only certain thing is that the Federal Reserve needs to fight inflation," said Althea Spinozzi, a senior fixed-income strategist at Saxo Bank. "That should be enough to say that it will at least hike by 25 basis points, and it cannot disappoint markets."

Still, Spinozzi said market expectations and views on the Fed's commitment to fighting inflation could further bond market volatility.

"The Federal Reserve is trapped between the possibility of provoking a taper tantrum or an inflation tantrum," Spinozzi said. "Either way, the market is going to remain volatile and if the Fed disappoints, either way, a selloff is likely to ensue."

Balance sheet

Also at issue is the anticipated reduction of the Fed's nearly $9 trillion balance sheet, which could impact the central bank's plans to hike rates. The minutes gave no timeline or specific details of that runoff but said participants saw a "faster pace" and a "significant" reduction as appropriate.

"Will the Fed hike 25 or 50 bps in March?" said Tom Essaye, a trader and founder of Sevens Report, in a Feb. 17 note. "How quickly will the Fed reduce the balance sheet? Those answers will determine whether the Fed is viewed as more hawkish … or not as hawkish."

A hawkish Fed, pushing for larger and more rate hikes, would likely continue to push up bond yields at the front end of the yield curve. This would continue to flattening the yield curve and potentially lead to an inversion, where shorter-term bond yields go higher than longer-term yields, a strong predictor of a coming recession.

Peak of uncertainty

Monetary policy is at the "peak of uncertainty," not only at the Fed, but at central banks throughout the world, said England with Janus Henderson.

In the early days of the pandemic all central banks, in response, took rates on a rapid elevator ride down. Now all these central banks are taking different escalators up at different speeds, adding to the uncertainty.

For the Fed "that escalator is becoming faster and much steeper," England said.

The uncertainty will likely last until the Fed announces its rate hike plan after the March meeting, said Antoine Bouvet, a senior rates strategist with ING.

"Once the first hike is behind us and the Fed publishes a new set of forecasts, we will probably be a bit clearer about how [the Fed wants] to proceed in this cycle," Bouvet said. "The Fed will remain data-dependent and so will keep its options open but the March decision and voting pattern will help reduce the uncertainty."