On September 17, 2024, construction work was completed around the Federal Reserve Building in Washington, DC.
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The Federal Reserve cut interest rates beyond normal last week, sending a clear message that interest rates will be significantly lower in the future.
However, the Treasury market did not attract attention.
Even though the Federal Reserve approved a half-percentage-point cut in its benchmark short-term borrowing rate, Treasury yields have been moving higher, especially on the long end of the curve.
The 10-year Treasury yield, considered the benchmark for government bond yields, has jumped about 17 basis points since the Sept. 17-18 Federal Open Market Committee meeting, reversing a sharp decline throughout September. 1 basis point equals 0.01%.
10-year Treasury bond yields rise
For now, bond market professionals are unwinding a large portion of this measure as simple compensation for markets pricing in too much easing ahead of the Fed meeting. But the trend is worth watching because it could be a sign of more ominous things to come.
Other reasons for the move include the Fed’s willingness to tolerate higher inflation, as well as concerns about the U.S.’s precarious fiscal position and the possibility that a heavy debt and deficit burden could increase long-term borrowing costs no matter what the Fed does. .
“To some extent, people are believing the rumors and selling the facts as it relates to the actual FOMC decision last week,” said Jonathan Duensing, head of U.S. fixed income at Amundi US. “Markets have been Discounted a very aggressive easing cycle.”
In fact, the rate cut that the market has priced in has been higher than what Fed officials indicated at the meeting, even if the cut was 50 basis points. Officials expect to cut interest rates by another 50 basis points by the end of this year and by another 100 basis points by the end of 2025. of the trading house Fed Watch tracker.
But while yields on longer maturities such as the 10-year bond have soared, yields on bonds at the shorter end of the curve – including the much-watched ones – have risen sharply. 2 year note ——Not moving much at all.
This is where it gets tricky.
Observe the curve
The spread between the 10-year and 2-year Treasury notes has widened significantly since the Fed meeting, widening by about 12 basis points. This movement, especially when long-term yields rise faster, is known in market terms as “bear market steepening.” That’s because it generally coincides with when the bond market expects higher inflation in the future.
That’s no coincidence: Some bond market experts interpreted the Fed official’s comments as: There is now a greater focus on supporting a weak labor market, acknowledging their willingness to tolerate slightly above-normal inflation.
This sentiment is evident in the “break-even” inflation rate, or the difference between standard Treasury bond and inflation-protected Treasury bond yields. For example, the five-year breakeven rate has risen 8 basis points since the Fed meeting and 20 basis points since September 11.
“The Fed’s shift makes sense because they believe inflation is under control, but they see unemployment rising and job creation clearly not enough,” said Robert Tipp, chief investment strategist for fixed income at PGIM. Long-term yields The rise “definitely suggests that the market sees the risk that inflation could go higher and the (Fed) won’t care.”
Fed officials are targeting 2% inflation, but no major indicator has yet been achieved. The closest is the Fed’s favorite personal consumption expenditures price index, which was at 2.5% in July and is expected to be at 2.2% in August.
Policymakers insist they are equally focused on ensuring that inflation does not get better and start heading higher, as has happened in the past when the Fed eased monetary policy too quickly.
But the market believes that the Fed will pay more attention to the labor market and will not push the broader economy into an unnecessary slowdown or recession caused by excessive tightening.
Possibility of significant cuts in the future
“We collectively believe what the Fed and Chairman (Jerome) Powell are saying is that they will be very data-reliant,” Duensing said. “As we move into the upcoming post-election meeting as it relates to the softness in the labor market, they “Very willing and interested in another 50 basis points cut. They are ready to approve whatever adjustments are needed at this time.”
Then there’s the issue of debt and deficits.
Rising borrowing costs push up the cost of financing this year’s budget deficit Breaking through the $1 trillion mark for the first time. While lower interest rates will help ease that burden, long-term Treasury buyers may be afraid to invest in a fiscal situation with a deficit approaching 7% of GDP, which is almost unheard of during a U.S. economic expansion.
Taken together, the various dynamics in the Treasury market make for a difficult time for investors. All fixed-income investors interviewed for this article said they were reducing allocations to U.S. Treasuries as conditions remain fluid.
They also believe the Fed may not stop cutting interest rates sharply.
“If we start to see the (yield) curve steepen, then we may start to sound the alarm about the risk of a recession,” said Tom Garretson, senior portfolio strategist for fixed income at RBC Wealth Management. “ They’re probably still hoping for at least another 50 basis points hike this year. People are still concerned that they’re coming too late.”
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