Fed Cuts, Yet 10-year Rises
Co-Author: Kevin Strauss, Portfolio Manager
The Federal Reserve (Fed) cut rates for the first time post-Covid in September, yet in the past month the 10-year Treasury yield has risen to more than 4% (up from 3.6%). While this may confuse some investors, the Fed Funds is an overnight rate at which banks borrow and lend excess reserves. Therefore, the Fed has direct control of the Fed Funds rate. While the Fed can influence long-term Treasury rates by creating incremental demand or supply (as a buyer or seller of Treasuries), the 10-year Treasury yield is determined by the market. Additionally, the Fed Funds rate and long-term (10-30 years) rates are influenced by different factors. Short of a significant economic slowdown or geopolitical event, investors should appreciate that the Fed Funds and 10-year Treasury yield can move independently.
Regarding the Fed Funds rate, the Federal Reserve’s dual mandate is to promote maximum employment and stable prices (approximately 2% inflation). This makes Fed behavior much more sensitive to the near-term outlook (0-2 years) for the economy. The aspect where the Fed cares deeply about the medium and long-term outlook is primarily regarding inflation expectations. Inflation is heavily influenced by expectations. If a business thinks labor and input price costs are going to rise, it will raise prices. If an employee believes that prices are likely to rise, the employee will demand higher wages. Therefore, the Fed wants to maintain credibility regarding its ability to manage inflation over the medium and long term. Regarding our outlook for the Fed Funds rates, we expect the Fed will cut rates by 0.25%, perhaps even 0.50%, cumulatively, at the two remaining FOMC meetings in 2024. While inflation has moderated, economic growth and employment remain too strong for the Fed to feel compelled to cut further. The Fed, as it repeatedly states, is data dependent and if the economy were to slow significantly, more cuts would likely occur. But after years of hoping for significant cuts in the very near term, the market finally seems to accept that the need for rapid rate declines is not present and the Fed is not in a rush. The Fed likely prefers to keep rates higher when the economy is strong, allowing it more flexibility to be accommodative, if necessary.
Concerning the recent rise in the 10-year Treasury yield post Fed cut, many factors are at play here. First, the near-term economic growth outlook remains strong so the Fed does not need to rush to cut rates. Second, while inflation has moderated from the very elevated levels of a few years ago, it is still well above 2%. Will it moderate further, given the significant long-term supply chain and geopolitical concerns? Companies value the certainty of their supply chains, and Covid created significant concerns of operating a just-in-time global supply chain that can be severely impacted by disruptions. Third, the government debt burden continues to grow. For context, the U.S. has not run a government surplus since 2001, and Federal debt outstanding has increased by more than 50% in the last five years. Furthermore, the interest burden on this debt continues to grow rapidly, driven by a higher debt load at higher rates. Fourth, the bond market is likely pricing in some risk of a Republican or Democratic sweep (President, Senate and House). The current betting odds of an all-Republican or all-Democratic sweep is over 50%. Based on non-partisan analysis, both Presidential nominees’ economic agenda would add to the Federal Deficit. These four factors help explain why the Fed can cut the Fed Funds rate by 0.50%, even as the 10-year Treasury yield can rise over 0.40%. Regarding mortgage rates and the 10-year yield, media/social media sometimes imply that the Fed cutting rates may lower mortgage rates. This is generally not true, since most homeowners get a 30-year fixed rate mortgage, and the rate on these mortgages is driven primarily by the 10-year Treasury rate. Since most mortgages do not last the full 30 years, and mortgages require principal paydown throughout the period, mortgage rates track the 10-year Treasury yield more than the 30-year. This dynamic explains why mortgage rates have actually risen since the Fed cut (also by approximately 0.40%).
To summarize, fixed income has had a strong 2024, and over the past twelve months investment grade bonds have returned over 10%. Looking forward, Investment grade bond yields remain well over 4.5% and high yield bonds remain in excess of 7% (heavily skewed by the weakest credits). We remain confident on the potential for a portfolio of quality, intermediate corporate bonds and preferreds to contribute positively to your portfolio. However, we would caution clients against chasing yield by either increasing duration (interest rate exposure) or accepting credit risk by owning lower quality credits. Based on history, the likelihood of credit spreads tightening significantly from current levels is quite low (see graph below). Additionally, if either party sweeps the upcoming election, we could see long-term rates rise meaningfully. Therefore, now is simply not a logical time to chase yield.
The market is dynamic and compelling opportunities will present themselves in the future.
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