Good Morning,

 

The Fed faces a conundrum. It has cut policy rates by 75 basis points since September only to see longer-term Treasury yields and mortgage rates increase by the same degree.

 

Today we’ll look at what may be driving this divergence and the potential implications for lenders, borrowers, and the economy.

 

This isn’t the first time the Federal Reserve has faced a conundrum. Former Fed Chair Alan Greenspan famously used the term in reference to monetary policy at a point in time when the Fed had raised overnight interest rates by 150 basis points (bps) without any material increase in longer-term Treasury yields.

 

In theory, the Fed’s adjustments to its overnight lending rate should echo through all interest rates. This is not always the case.

 

That lack of follow-through was just one factor that kept borrowing rates, including mortgage rates, low despite the Fed’s efforts to raise rates…..and we know how that ended—with low mortgage rates contributing to a broad housing bubble.

 

Now Fed Chair Jerome Powell may be staring down his own challenge—but in reverse.

 

After an outsized 50 bps rate cut in September, the Fed followed through with a 25 bps reduction last week to bring its policy rate target to a range of 4.50 % to 4.75 %. As the first chart shows, markets have not taken notice. The 10-year Treasury yield has been on a one-way trip higher, up nearly 80 bps to around 4.50 % this week, with few signs of slowing down.

 

While much of the rise in yields has been attributed to better economic data after a labor market scare in August, the potential policies of the incoming administration, amplified by the Republican Party officially retaining control of the House this week for a trifecta of control, has certainly been a factor.

 

Naturally, Powell wanted no part in entertaining the implications of potential policy proposals, stating last week, “Here, we don’t know what the timing and substance of any policy changes will be. We therefore don’t know what the effects on the economy would be, specifically, whether and to what extent those policies would matter for the achievement of our goal variables, maximum employment and price stability. We don’t guess, we don’t speculate, and we don’t assume.”

 

But markets do all those things! Let’s now explore what they might be telling us.

 

 

Better Economic Data Will Mean Fewer Rate Cuts

The bulk of the rise in Treasury yields despite Fed rate cuts is due to fundamentals. Various economic surprise indexes have been trending higher for months now and have been closely correlated with Treasury yields. After a surprisingly weak payrolls report for July, markets priced in entirely too many rate cuts from the Fed. The recent rise in Treasury yields is simply a repricing of a better-than-initially-feared economic reality.

 

The 10-year Treasury yield is impacted by two components: Expectations for the Fed’s policy rate and for inflation.

 

Better economic data has been reflected in fewer Fed rate cuts ahead. Of the roughly 80 bps rise in the 10-year Treasury yield since September, 50 bps likely can be explained by fewer rate cuts priced over the next year.

 

Inflation Expectations Could Be Reset

The other component embedded in 10-year Treasury yields, inflation, explains the balance.

 

The Treasury Inflation-Protected Securities (TIPS) market tells us the market’s inflation expectations, which have risen by about 30 bps since September. Markets now expect inflation to average 2.35 % over the next decade, compared to a low of 2.05 % in September.

 

While Donald Trump’s return to office may have been a modest surprise to some, it was simply the latest outcome in a long list of global referendums on inflation this year that saw multiple governments around the world dismissed in favor of new ones.

Seemingly above and beyond anything else, people simply dislike inflation, and incumbent governments finally paid the price for it this year, in our opinion.

 

The irony, of course, may ultimately be that those who voted against inflation may actually face more of it as a result, based on current market expectations.

 

If this truly is the case, it would be reasonable to expect even greater deficit risks under proposed policy plans, which would be amplified by greater interest costs on the federal debt. Ultimately - if those policy plans mean that interest rates will have to remain higher, and for longer.

 

For consumers, (second chart), mortgage rates are again rising on the back of higher Treasury yields, which could further stress housing affordability.

 

Perhaps the only good news is that while it may be getting more expensive to borrow money, that can only mean it’s getting more attractive to lend it.

 

For investors, worried that Fed rate cuts could end a stretch of historically attractive yields, the fixed income landscape may remain fertile land for some time longer. The days of pro-growth policies and bigger deficits, at least over the near term, will likely keep interest rates elevated for an extended stretch.

 

As for the Fed, there’s probably little policymakers can do to stem the rise in yields. Cutting rates further would likely have little impact and might only add to inflationary fears. Should the dynamic of “economy too strong” persist, policymakers could pivot back to rate hikes later in 2025…meaning that yield curves reinvert.

 

In the end, there is no such thing as a free lunch. While markets remain optimistic about growth and deregulation, fixed income markets are sending warning signs that there is still likely to be a price to pay for it.

 

As always, please let me know if you have any questions or comments.