A paradoxical phenomenon occurred in the course of US interest rate cuts: Instead of falling, they moved higher in the medium term.
The Federal Reserve cut its key interest rate by half a percentage point in September, raising expectations that other interest rates will soon begin to cut as well. By contrast, two-year and 10-year bonds and the average 30-year mortgage rate have all risen half a percentage point or more.
With no surprises on Thursday night 7/11 the Federal Reserve proceeded with the expected reduction in interest rates by 25 basis points, to a range of 4.50%-4.75%. It is the second rate cut since the early days of the pandemic, with policymakers pointing out that the labor market has “broadly eased” while inflation continues to move toward the Fed’s 2% target. Bank of the USA.
After all, FED officials have justified the way monetary policy is being eased, as they believe that supporting employment is becoming at least as important a priority as containing inflation – in line with the central bank’s mandate.
“Economic activity continued to expand at a steady pace,” the Fed said in its unanimous decision.
What happened? The short answer is that the Fed does not have complete control over interest rates.
The bond market also has a lot to say about interest rates — particularly longer-term ones, though not exclusively. Bond market reaction is a simple reflection of supply and demand. The key is to understand that bond yields and prices move inversely – when one goes up, the other goes down.
The 30-year mortgage rate is one of the rates based on the bond market that was falling before the Federal Reserve cut its benchmark rate on September 18, but has risen since then!
Let’s see the reasons:
For example: If I buy for $100. US a bond that yields 5%, I will receive $5. per annum in interest. But suppose I sell the bond, and because demand is sluggish and supply is strong, you only pay $90. (price reduction).
Now you get $5. per year in interest, but because you paid $90, your return is 5.55% (yield increase). (If, instead, you had to pay $105 for the bond, your yield would be 4.76% to see the price/yield ratio in market terms).
So what’s happening is that while the Fed is now trying to push interest rates down, bonds are selling off and that’s pushing interest rates higher.
The question is: Why is the bond market bearish?
There are at least two possible answers.
1. Some analysts blame what they call “Tramp trade”.
The markets had discounted that Trump would win the presidency. In addition, they believe that a second term will worsen the already bad trend of the federal debt and bring higher inflation.
Markets have no political agenda. Bond investors could be wrong about the implications of a Trump victory — but their predictions are not an expression of anti-Trump bias.
Their decisions to buy and sell bonds reflect their estimates of inflation. Creditors fear being repaid in depreciated dollars if inflationary policies are pursued – such as extensive tax breaks or the imposition of tariffs that will suddenly push prices up.
2. The other explanation for the bond selloff is the state of the economy.
The Fed’s rate cut on September 18 reflected an economy that was barely adding 100,000 new jobs a month. But in early October, the Bureau of Labor Statistics reported a gain of 254,000 jobs in September, well above the 12-month average, and the agency revised some of the previous months upward.
Meanwhile, the rate of inflation in September continued its downward path towards the Fed’s 2% target, but did not fall as much as expected. With those reports, November’s half-point rate cut by the Fed looked less likely.
The Nov. 1 report of just 12,000 more jobs in October echoed the effects of major storms and the Boeing strike. Financial markets are forward-looking, predicting events. In anticipation of the Fed tapering in September, investors had bought bonds, which pushed bond yields lower.
In light of data showing a stronger economy and worse-than-expected inflation in September, investor expectations have shifted. If the Fed wasn’t going to cut rates as much or as quickly as expected, markets had to adjust.
It’s possible, of course, that the real answer is some combination of the Trump trade and expectations of future Fed rate moves.
If investors were selling bonds in fear of higher deficits and inflation, we should ask ourselves – why now?
Bond investors have ignored years of multitrillion-dollar federal budget deficits. If these deficits now begin to worry bond investors, it would signal a return to a state of vigilance.
In the early years of the Clinton administration three decades ago, bond investors’ concerns about federal spending drove 10-year yields to 8% from 5.2% in one year. The administration was forced to work with Congress on plans to curb spending and, years later, even ran a budget surplus.
Having to be pressured by the markets to do this led one Bill Clinton adviser, James Carville, to say – famously – that if he could be reincarnated into anything else, it would be the bond market to scare everyone.
For farmers, ranchers and other business borrowers, the big question is where interest rates go from here.
The most likely path is for them to go down, although perhaps more slowly than many analysts thought in September.
The US economy is strong and inflation is basically under control. Barring even faster economic growth – a highly unlikely scenario – and barring a resurgence of inflation – possible, but not highly likely – the current level of interest rates is much higher than current economic conditions require. Based on the data above, the Fed will continue to cut, maybe only quarterly cuts and maybe not every meeting, but in a few years, its benchmark rate will be closer to 3% than 5%.
As the Fed moves in that direction, markets will eventually align – especially if whoever wins the presidency is constrained, by Congress or the bond market or a return to common sense, from implementing Donald Trump’s more inflationary promises.
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