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Monday, November 11, 2024

Fed Cuts Rates, Yields Rise: What’s the Disconnect?

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Fed’s Rate Cut Ignored: Treasury Yields Rise, Signaling Uncertainty

The Federal Reserve’s significant interest rate cut last week, a half-percentage point reduction, aimed to signal a path towards considerably lower rates in the future. However, the Treasury market reacted unexpectedly, with yields, particularly at the longer end, climbing instead of falling. This counterintuitive response has sparked concerns among market professionals, who are weighing the implications of this development and its potential significance for the economy.

Key Takeaways:

  • Despite the Fed’s 50 basis point rate cut, Treasury yields, especially the benchmark 10-year note yield, have risen, reversing a previous downward trend.
  • This move, a “bear steepener,” where longer-term yields rise faster than shorter-term ones, often signals market anticipation of higher inflation.
  • Analysts cite several factors contributing to the yield increase: market overestimation of rate cuts prior to the Fed meeting, the Fed’s tolerance for higher inflation, and concerns about the U.S. fiscal situation.
  • The discrepancy between market expectations (200 basis points of cuts by end of 2025) and the Fed’s projections (150 basis points) adds to the uncertainty.
  • Investors are increasingly cautious, reducing Treasury allocations as market volatility persists.

Watching the Curve: A Bear Steepener Emerges

The divergence between the behavior of short-term and long-term Treasury yields has created a significant “bear steepener.” The gap between the 10-year and 2-year note yields widened by approximately 12 basis points post-Fed meeting. This is noteworthy because rising long-term yields while short-term yields remain relatively stagnant often reflect market expectations of future inflation.

Inflationary Pressures and Fed’s Stance

Some analysts believe the Fed’s focus on supporting the softening labor market indicates a higher tolerance for inflation than previously communicated. This is supported by rising “breakeven inflation rates,” which represent the difference between yields on standard Treasury bonds and those on Treasury Inflation-Protected Securities (TIPS). The 5-year breakeven rate, for instance, increased by 8 basis points after the Fed meeting and 20 basis points since September 11th. Robert Tipp, chief investment strategist at PGIM Fixed Income, noted, “The Fed has justifiably shifted because they’re confident inflation is under control but they’re seeing a rise in unemployment and a rate of job creation that clearly appears to be insufficient. The rise in long-duration yields ‘is definitely an indication that the market sees risks that inflation can be higher and [the Fed] will not care.‘”

Possibility for Big Cuts Ahead: Market Uncertainty Remains

Despite the unexpected yield increase, several fixed-income investors believe the Fed might not be finished with substantial rate cuts. Jonathan Duensing, head of U.S. fixed income at Amundi US, stated, “We’re taking collectively the Fed and Chair Powell at its word that they’re going to be very data dependent. As it relates to the softening in the labor market, they are very willing and interested to cut another 50 basis points here as we get into the post-election meetings coming up. They stand ready to approve any accommodation they need to at this point.

Fiscal Concerns and Investor Sentiment

The current U.S. fiscal state adds another layer of complexity. Higher borrowing costs have pushed interest payments on the national debt over the $1 trillion mark for the first time this year. While lower rates would alleviate this burden, the looming deficit approaching 7% of GDP raises concerns among investors regarding long-term borrowing costs, irrespective of Fed actions. This uncertainty is driving many investors to reduce their Treasury holdings.

Recession Risks and Future Fed Moves

The potential for a steepening yield curve raises concerns about recession risks. Tom Garretson, senior portfolio strategist for fixed income at RBC Wealth Management, points out, “If we start to see that [yield] curve steepen, then we probably start to set the alarm bells off on recession risks. They’d still probably like to follow through with at least one more 50 basis point move this year. There’s still an ongoing, lingering fear here that they’re a bit late to the game.” The Fed’s commitment to data dependency and its dual mandate of price stability and maximum employment creates a challenging environment for market participants to predict future policy decisions.

In conclusion, the Fed’s recent rate cut has yielded unexpected results, underscoring the complexities and uncertainties within the current economic landscape. The rise in Treasury yields, alongside market expectations and evolving fiscal realities, paint a picture of a market grappling with shifting dynamics and awaiting clarity on the Fed’s future course. The coming months will be critical in deciphering whether this is a temporary market anomaly or a harbinger of more significant economic shifts.


Article Reference

Amanda Turner
Amanda Turner
Amanda Turner curates and reports on the day's top headlines, ensuring readers are always informed.

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