Bond yields have been doing a lot of the heavy lifting for the Federal Reserve by helping keep inflation in check — but that’s coming back to bite the central bank.
The swift rise in long-term US Treasury yields over the past few months caused headaches for investors by dragging many of their portfolios down. For the government, it made it more expensive to borrow money.
But their loss was the Fed’s gain. The rise in yields took the pressure off Fed officials to act before getting new data offering a more complete view of the current state of the economy.
Bond yields, namely the yield on the 10-year Treasury note, dictate the interest rates on credit cards, mortgages and auto loans. When those rates go up, borrowing money becomes more expensive. The same is also true when the Fed raises interest rates.
Fed Chair Jerome Powell addressed that at this month’s post-meeting press conference, saying he couldn’t pinpoint exactly why yields rose so much in recent weeks. However, he said that “perhaps the most important thing is that these higher Treasury yields are showing through the higher borrowing costs for households and businesses and they will weigh on economic activity to the extent that tightening persists.”
In addition to Powell, several other Fed officials have also suggested that if yields remain elevated the Fed could afford to skip more rate hikes at future meetings.
Kathleen O’Neill Paese, the interim president of the St. Louis Fed, said on Thursday that she supported the Fed’s decision to hold rates steady at November’s meeting due to “the tightening of financial and credit conditions that has occurred over the past two or three months.” She added that’s reflected “in higher yields on long-term Treasury.”
The only problem is yields haven’t been good at sitting still.
Hours before Powell’s post-meeting remarks, bond yields plunged following the Treasury Department’s quarterly refunding announcement. To investors’ surprise, the Treasury said it would be auctioning a slightly smaller amount of debt than they expected. On top of that, Powell’s remarks helped convince Wall Street that the Fed finished hiking interest rates, even though he didn’t say it outright.
Fed officials “will always give themselves optionality and therefore would never signal that rate hikes are over, especially given the strength of the growth data and labor market,” said John Madziyire, head of US Treasuries at Vanguard.
But the Fed’s latest statement, which added that “financial” in addition to credit conditions were helping slow the economy “suggested the market had done some of the work for the Fed,” said Joe Kalish, chief global macro strategist at Ned Davis Research.
That sent yields even lower. From October 19 to November 8, the yield on the 10-year Treasury note fell from nearly 5%, the highest level since 2007, to around 4.5%.
That effectively is a rate cut. It immediately translated to a sharp decline in mortgage rates last week, the biggest plunge in a year. Lower mortgage rates are especially counterproductive at a time when the Fed is fighting valiantly to bring inflation down to its 2% target while the economy remains at risk of overheating.
But some investors saw things differently, Kalish told CNN. They were relieved that the Fed seemed less inclined to “overtighten and drive the economy into a recession,” he said.
This “put the Fed in a pickle,” Bank of America economists wrote in a note on Friday.
That helps explain why Powell sought to dismantle investors’ belief that the Fed is done hiking.
“We know that ongoing progress toward our 2% goal is not assured: Inflation has given us a few head fakes,” Powell said Thursday at a conference hosted in Washington, DC, by the International Monetary Fund. “If it becomes appropriate to tighten policy further, we will not hesitate to do so,” he said.
That immediately sent yields higher and robbed the S&P 500 of what would have been the index’s longest stretch of daily gains since 2004 as more investors started predicting a rate hike at the Fed’s final meeting of the year.
“Going forward, it may be that a greater share of the progress in reducing inflation will have to come from tight monetary policy,” Powell said. That’s as opposed to letting bond yields do the Fed’s work for it.
Bank of America economists said the central bank “will have to accept the circular relationship between financial tightening and its response to financial tightening.” In other words, the Fed will need to be more careful not to undo financial tightening when it arises in the bond market by signaling to investors that it’s a substitute for a rate hike.
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