Financial markets update: Our new call on rates

Investors had been anticipating the Federal Reserve’s first cut in the federal funds rate for nearly a year. It finally happened on Sept. 18.

The bond market’s expectations had already resulted in a notable decline in 10-year bond yields. By the second week of August, investors had pushed 10-year Treasury yields to 3.8%, a significant move below their 4% to 4.5% trading range since January, and then to between 3.6% and 3.7% in the days preceding the September announcement.

This stood in contrast with the 4.2% average for the year and our previous year-end call for 4.25%. As a result, we are updating our year-end rate call to 3.7% on the 10-year yield.

In some respects, the market was doing the Fed’s work, with investors front-running the first rate cut. Longer-term rates along the curve are resetting, and short-term rates are about to fall.

We anticipate that the reductions will unlock cash flows among firms and households and unleash pent-up demand for housing, autos and capital expenditures that are key to improving productivity.

The question for decision makers, then, is not if the Fed will continue to cut rates, but by how much.

How long?

The question for financial market participants is how long to wait to take profits on bond holdings. The question for senior executives is how long to wait before acting on delayed investment decisions.

Businesses, after all, must achieve a return on invested capital greater than their weighted average cost of capital. As that cost falls, firms will increase capital expenditures, which will bolster overall growth.

A new paper by the Bank for International Settlements documents that U.S. monetary policy shocks since the financial crisis have had persistent effects on longer-dated Treasury yields, with different responses to rate hikes and rate cuts.

The analysis by Tobias Adrian, Gaston Gelos, Nora Lamersdorf and Emanuel Moench finds that since the financial crisis, monetary policy tightening appears to lift yields for only a limited number of weeks, followed by a decline.

By contrast, the response to easing is for yields to move persistently lower.

The authors also write that the slow and persistent reaction of flows to bond mutual funds is likely to account, at least partly, for the observed persistence.

Finally, the authors find that these patterns hold globally, with advanced-economy and emerging-market sovereign yields reacting to U.S. monetary policy shocks.

We can look at bond yields as the sum of expectations of the path of overnight monetary policy rates and the term premium, which is compensation for the risk of holding the security over its maturity.

You would expect shorter-date yields to react more to expectations for short-term rates than to the risk of holding the security.

For example, two-year Treasury yields are the present value of expectations for the federal funds rate over the next two years. In May 2024, the two-year bond was yielding 5.03%. Four and a half months later, two-year yields dropped 140 basis points to 3.6%.

Conversely, you would expect longer-term securities to incorporate expectations for the health of the economy.

In our view, the drop in the term premium for 10-year Treasury bonds into negative values after the financial crisis reflected the risk of deflation and economic collapse.

This was the case when the recovery from the financial crisis was disrupted by government dysfunction between 2009 and 2020.

In recent weeks and months, however, we’ve attributed the negative term premium to the risk that the Fed had kept short-term rates too high for too long.

The slightly negative term premium leading up to the Fed’s easing can be seen as a hedge against the potential negative impact of continued inflation and, now, a weakening labor market.

In recent years, with interest rates so low and with a term premium that was more or less neutral, 10-year bond yields have closely tracked expectations of short-term rates.

This has been the case since 2017, when uncertainty took hold of the markets as the economy was buffeted by a series of shocks.

If all goes to plan and the fiscal and monetary authorities have ushered in a period of growth and stability, we can expect the bond market to return to normalcy.

What comes next?

If inflation continues to recede, we expect the federal funds rate to drop from its current 5.25% to 5.5% range to as low as 3% to 3.5% next year. While the market might prefer the Fed to signal a gradual pace of 25-basis-point cuts, we cannot rule out either pauses in policy or 50-basis-point cuts should the data suggest otherwise.

For instance, if the effect of government investment in infrastructure and the private sector’s investment in productivity were to take hold quicker than expected (or if the debt overload were to be neglected), the setting of the federal funds rate could conceivably pause at a higher range.

In terms of predicting 10-year yield levels, the rate cuts and the removal of recession risk imply the term premium returning to moderately positive values in the near term.

This would likely occur as short-term rate expectations decrease, moderating the decline in yields once the trading frenzy after each rate announcement has dissipated.

In the longer term

A range of models that we use to estimate where yields are and where they might end up in the long term indicates a range of outcomes.

The first model estimates the 10-year yield of 3.6% as the sum of expectations of the short-term rates of 3.87% plus a still negative term premium of minus 0.26%.

The second estimate of 3.73% relies on values from the Treasury inflation-protected securities (TIPS) market, which estimates a 10-year yield as the sum of the real 10-year yield of 1.58% plus the implied value of inflation compensation of 2.15%.

The third estimate posits that in the long run, 10-year bond yields at 4.3% would reflect the economy growing at its current estimated potential of 1.8% per year, plus a de facto inflation target of 2.5% per year. A higher inflation target implies the Fed’s recognition of changes in the supply chain and in the labor market that will tend to keep price pressures higher than in the previous period of an overabundance of cheap goods.

While 4.3% bond yields might seem excessively high compared with the cheap money available during the era of near-zero rates from 2009 to 2022, post-pandemic-era rates will almost surely capture a positive term premium and higher rates as higher inflation leads to the end of easy money.

Excessively low interest rates should be viewed as an aberration, and that era has ended.

Normalization of the yield curve

The Treasury yield curve provides the market estimates of where the federal funds rate and economic growth will end up in two years.

Because the two-year Treasury bond yield is determined as the present value of the federal funds rate over the next two years, the current 3.6% two-year yield can be seen as the federal funds rate falling from 5.5% to less than 3.6% over two years.

That decline coincides with our forecast of a terminal federal funds rate in the range of 3% to 3.5%.

Because the current 10-year yield of 3.73% is now higher than both the two-year and five-year yields, the newly reestablished upward sloping yield curve suggests a normal financial system generating appropriate returns on short- and long-term investments.

Increased volatility

The second-guessing of the Fed’s reluctance to cut the federal funds rate and the loss of confidence in the technology sector’s ability to continue generating outsize earnings have injected additional risk into the bond and equity markets.

Those concerns were amplified when Japan’s monetary authorities began the process of abandoning their zero interest rate policy, which threatened the yen carry trade as well as the attractiveness of U.S. securities for Japan’s investors.

In the bond market and before the turmoil that the unwinding of the yen-based carry trade unleashed, the MOVE index of Treasury bond volatility had just dropped to its long-term average.

The index has since increased and will most likely remain elevated as the front end of the yield curve normalizes.

While volatility presents opportunities for bond traders, the Treasury market’s safe-haven investments, particularly at the front of the yield curve, offer retail and institutional investors the opportunity for higher returns.

By Aug. 5, the VIX index of S&P 500 options volatility had jumped to its highest level in five years. The VIX receded after that as the equity market regained its footing. The less volatile 30-day volatility measure of the S&P 500 calculated by Bloomberg remains above its long-term average.

While traders might characterize the yen carry trade episode as a warning shot, similar to the 2007 volatility increase before the financial crisis, investors more confident in the potential of corporate earnings can point to the 12% average annual returns of the S&P 500 over the past 15 years.

Credit spreads

Since the investment-grade (Baa) credit spread peaked in 1982, its long-term decline has been broken only during major disruptions to the business cycle.

So far, and with the Fed now pivoting to lower rates, the turmoil stemming from the yen carry trade remains a blip compared to bigger meltdowns in the past. 

Conditions remain somewhat restrictive

Overall, financial conditions remain restrictive but close to neutral. This coincides with the Fed dealing with its dual mandates for price and employment stability at a time when food prices remain high and the labor market, though healthy, is cooling.

In the week of the Fed announcement, the money market and bond market components of the RSM US Financial Conditions Index remained negative, while the equity market shook off its concerns. 

Those readings add up to the RSM US Financial Conditions Index holding at 0.46 standard deviations below normal as of Sept. 19, suggesting slightly more risk than would otherwise be expected.

Our index was formulated to anticipate the willingness of banks to make loans to businesses and to anticipate economic growth.

The current tepid level of financial conditions suggests the lingering impact of a higher cost of credit on both lenders and borrowers. While the economy is now growing at a 2.9% annual rate, rate cuts will undoubtedly be necessary for the economy to continue to grow at rates above its long-term potential of 1.8%.

The centrality of the U.S. financial system

The idea that the United States can or should go it alone is a recurring populist idea that ignores the importance of the U.S. financial system to worldwide trade, growth and finance, as well as the importance of foreign investment in the U.S. economy.

The findings of the BIS paper are that U.S. policy shocks are determinants of financial conditions throughout the advanced and emerging economies of the world.

In our view, government-induced disruptions to the U.S. bond market will likewise have an effect on global economic activity, with severe consequences for the U.S. economy. It would be a self-inflicted wound.

The most glaring example of the worldwide effect of a U.S. financial shock was the Lehman Brothers collapse in 2008.

The Treasury Department chose not to force Lehman’s sale, which led to a global financial crisis and a near depression.

The worldwide reaction to changes in Fed policy illustrates the importance of protecting the safety of investing in the U.S. bond market.

The takeaway

As we expected, the Fed has joined other central banks among the developed economies (with the exception of the Reserve Bank of Australia) that had already begun lowering their policy rates.

Still, the U.S. bond market will continue to provide the highest return to foreign investors.

In addition, the growth of the U.S. economy will continue to support those higher interest rates.

And finally, the adherence to the rule of law guarantees the safety of investment in U.S. companies. In the end, the attractiveness of U.S securities will continue.