Fed Goes Big Easy, Bond Markets Uneasy

Ten- And Thirty-Year Treasurys Rise in Yield

As September arrived, there was a lot of optimism about an impending rate cut by the Federal Reserve. Chairman Jerome Powell, as well as his senior colleagues on the rate-setting Federal Open Market Committee, had virtually assured markets that the first rate reduction since the start of covid in early 2020 would take place on September 18. And when the central bank reduces rate once, more easing will follow, right?

Powell and the FOMC delivered more than investors had hoped for, taking the Federal Funds rate down by a whopping 50 basis points rather than just 25. Both equity and Treasury holders were just as thrilled that the policymakers hinted at more rate reductions to come in a series of post-meeting speeches. Investors anticipate rates to be reduced by another 50bp before the end of 2024. Equities surged and Treasury yields plunged in the immediate aftermath of the Fed decision.

While equities have continued to march upward expecting steady economic growth, the sentiment appears to have shifted in fixed income markets. Compared with 3.62% on September 16 — start of the FOMC week — the yield on 10-year Treasurys closed last night at 3.75%. Over the same period, the yield on 30-year Treasury’s climbed from 3.90% to 4.11%.

At the short-end, on the other hand, expectation of continued reductions in the Federal Funds rate at forthcoming FOMC meetings pushed down the two-year Treasury yield. As the yield on long-dated securities rose in recent days while that on short-term securities fell, the yield curve that had been inverted for over two years has gone positive again. A “bear steepening” has occurred!

What message about the economy is the Treasury market conveying to investors?

The fall in the price of long-dated Treasurys stems from the policy easing that the Federal Reserve is intent on pursuing despite signs of strength in the economy. On Thursday, we learned that gross domestic product rose by 3% in the second quarter, accelerating from the 1.6% expansion in the first quarter. Initial jobless claims fell to a four-month low in the week ending September 21. Orders for durable goods were unchanged during August, compared with the decline in orders that the consensus had anticipated. And if you thought all this is just past history, the GDPNow estimate for the current quarter published by the Federal Reserve Bank of Atlanta accelerated to 3.1% on September 27, up from the 2.9% figure estimated on September 18.

Does yesterday’s PCE inflation numbers, the Fed’s favorite measure, justify the central bank’s jumbo rate cut? While equity and Treasury markets applauded the generally benign numbers, there were signs of trouble under the headlines. While the overall annual inflation number slowed to 2.2% last month from 2.5% in July thanks to a large decline in the price of gasoline over the past year, the core measure (which excludes food and energy) accelerated to 2.7% in August from 2.6% in the previous month.

Second, housing (viz., rents and owner-imputed rents) was a major factor in the latest PCE figures, as it has been for several recent months. It was a significant element in raising the latest annual core inflation rate. With the continued increase in home prices pushing more potential buyers into the rental market, rents are likely to remain a major inflationary force in the coming months.

Lastly, another factor to keep in mind is what is known as the “base effect”. High year-on-year inflation rates during the opening months of 2023 made for favorable comparisons for the corresponding months in 2024. The monthly inflation rates declined significantly in the final three months of the year, and this will make it difficult for the year-on-year numbers to post declines later this year.

“The fact that the US economy is growing at such a solid pace, the fact that the labor market is still very, very strong, gives us the chance to just be a little more confident about inflation coming down before we take the important step of cutting rates,” Powell said last March, emphasizing that the Fed does not need to be in a hurry to ease policy.

Recent actions just show that being the Federal Reserve means you do not have to practice what you preach!

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

September 28, 2024

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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