Rates Have Backed Up. What Next?

Not Quite the Message Powell Gave on December 13!

After closing 2023 at 3.88%, the yield on 10-year Treasurys rose as high as 4.15% on Thursday. Two-year Treasurys, often considered to be a reflection of market expectations regarding monetary policy, rose in yield over the same period from 4.25% to 4.33%, and further to 4.38% last night to close out the week. The two-year had traded as low as 4.14% on January 12. These are not the developments you would have expected if markets had kept their trust in the ultra-dovish message that Federal Reserve Chairman Jerome Powell provided on December 13.

In particular, does the rise in the two-year yield not suggest that no quick rate cut is in the cards?

Several factors are responsible for the backup in yields during the initial weeks of the new year. Senior Federal Reserve officials, realizing that Powell may have jumped the gun and made it more difficult to tighten policy if markets rally, made statements to dampen market enthusiasm. Prominent among these was John Williams, President of the Federal Reserve Bank of New York, often considered to be the second most important official in the central bank hierarchy. Williams emphasized that inflation is still way above the Fed’s 2% target despite a 5.25 percentage point increase in the Federal Funds rate since March 2022, and that no quick rate cut should be expected.

Federal Reserve Governor Christopher Waller’s statement Tuesday was one more nail in the coffin of rate optimism. While noting the progress made in mitigating inflation, he said bluntly, “I see no reason to move as quickly or cut as rapidly as in the past.” On Thursday, Raphael Bostic, President of the Federal Reserve Bank of Atlanta, said that he expected the Fed to start cutting interest rates in the third quarter — much later than in March as futures market suggests.

Data released since the start of 2024 have also gone against expectations of several rate cuts, or of the first reduction occurring at the Federal Open Market Committee meeting on March 19 - 20. Prominent among them, we learned that 216,000 non-farm jobs were created last month, much higher than the consensus expectation of 170,000. The same report from the US Bureau of Labor Statistics showed that average hourly earnings had risen by 4.1% in December compared with December 2022, accelerating from 4% in November. There was a similar acceleration recorded in the latest annual consumer price inflation.

Data released last week added to the raft of bad news for rate optimists. Principal among them, retail sales rose by 0.6% month-on-month in December, the biggest increase in three months. The figure exceeded the 0.4% increase that had been anticipated. The retail sales figure was the strongest indication so far that consumptions spending remains vibrant despite Fed tightening during 2022 - 2023. And on Thursday, we learned that initial jobless claims fell far below expectations at 187,000 suggesting a strong labor market. The consensus expectation had been for 207,000 jobless claims.

These factors, while relevant to the Fed’s decision-making process, do not take into account any upward pressure on inflation that could result from growing geopolitical tensions. Over the past week, add the attacks against each other by Iran and Pakistan to geopolitical risk. Iran is estimated to have produced 3.4 million barrels per day (MM b/d) at the end of 2023, equivalent to approximately 3.5% of global consumption. Any of the skirmishes could result in a sharp increase in energy prices, or cause renewed supply bottlenecks. The developments are important to consider but appear to have played little role in the Powell press conference on December 13.

What does all this mean for US interest rates? By keeping the potential alive for inflation to turn up, these economic and geopolitical developments could put upward pressure on both short-term rates and long-term yields.

Could the Federal Reserve be forced to raise the Federal Funds rate as its next move rather than cut it? An intriguing thought. Don’t be surprised if there is more discussion along these lines in coming months.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

January 20, 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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