As all METARs know by now, the Federal Reserve has been raising the short-term fed funds rate for over a year but did not raise it this week.
The Fed does not control longer-term bond yields. The market controls them. The Fed has been gradually allowing its immense book of Treasury and mortgage bonds to roll off as they mature.
The asset markets (stocks, bonds, real estate) have become addicted to QE (quantitative easing) – the suppression of yields by the Fed’s buying immense quantities of bonds since the 2008 financial crisis. Without the Fed’s heavy thumb on the scale, the market is gradually returning to normal. Will the Fed allow that to continue?
The historical real yield (over CPI-U inflation) of the 10 year Treasury was 2.0 - 2.5%. In August, the Consumer Price Index for All Urban Consumers increased 0.6 percent, seasonally adjusted, and rose 3.7 percent over the last 12 months, not seasonally adjusted. Today’s 10 year Treasury yield of 4.47% is the highest since 2007 but the real yield is still lower than the historical real yield. The market still believes that the 10 year breakeven inflation rate is 2.35%.
The Treasury yield curve has been rising much faster than the Fed is raising the fed funds rate.
By Greg Ip, The Wall Street Journal, Sept. 21, 2023
On Wednesday [September 20, 2023], Federal Reserve officials surprised markets by signaling interest rates won’t fall as much as previously planned.
The tweak might be more important than it looks. In their projections and commentary, some officials hint that rates might be higher not just for longer, but forever. In more technical terms, the so-called neutral rate, which keeps inflation and unemployment stable over time, has risen…
The neutral rate isn’t literally forever, but that captures the general idea. In the long run neutral is a function of very slow moving forces: demographics, the global demand for capital, the level of government debt and investors’ assessments of inflation and growth risks…
In 2026, officials project the economy growing at its long-term rate of 1.8%, unemployment at its long-run natural level of 4%, and inflation at its 2% target. Those conditions would normally be consistent with interest rates at neutral. As it happens, officials think the fed-funds rate will end the year at 2.9% — another hint they think neutral has risen…
For now, the evidence suggests the public should get used to higher rates as far as the eye can see. [end quote]
Fed Chair Jerome Powell has stated that he wants the Fed to maintain a neutral fed funds rate, which neither stimulates nor slows the economy, once they are confident that the inflation rate will be stable at their target of 2%. This is monetary policy.
At the same time, fiscal policy (controlled by Congress) is running large federal budget deficits. This will raise long-term interest rates as the bond market will become more reluctant to buy the huge and growing supply of Treasury bonds.
Higher long-term interest rates affect consumers, especially for mortgages and vehicle loans. The median American household needed 43.2% of its income to cover annual payments on a median-priced home as of June, according to the Atlanta Fed. That was close to the highest level ever recorded in data going back to 2006. The average monthly payment for a new car was around $725 in the second quarter and north of $500 for a used one, according to Experian data.
Higher long-term interest rates also impact businesses, especially ones with high debt that needs to be rolled over.
All asset markets will be impacted if the higher (though not especially high by historic standards) are here to stay for the long term. The gradually rising yield curve is a sign that the markets are beginning to believe this.