Capitalist free markets normally experience cyclical recessions and recoveries which affect the trends in bond yields. (Bond yields move opposite to bond prices.)
In a recession, bond yields usually fall and the prices rise. Conversely, during a recovery, bond yields usually rise and prices fall.
The Federal Reserve has meddled heavily in the bond markets by manipulating the fed funds (short-term) rate and also by buying immense quantities of Treasury and mortgage-backed securities, which they are gradually rolling off now.
The pre-2008 historic average real yield of the 10-year Treasury was about 2.5%. Fed repression pushed this to negative after the 2008 financial crisis and the Covid crisis as shown by the TIPS yield.
The Fed has finally allowed the bond market to approach a normal free-market level. The economy is strong as shown by GDP growth.
The financial markets have been betting on the Fed cutting the fed funds rate in March 2024 and predicting 6 cuts in 2024 as opposed to the Fed’s prediction of possibly 3 cuts. But is there any reason to cut?
The central bank is widely expected to lower interest rates this year. But with growth and consumer spending chugging along, explaining it may take some work.
By Jeanna Smialek, The New York Times, Jan. 30, 2024
Why would central bankers lower borrowing costs when the economy is experiencing surprisingly strong growth?
The United States’ economy grew 3.1 percent last year, up from less than 1 percent in 2022 and faster than the average for the five years leading up to the pandemic. Consumer spending in December came in faster than expected. And while hiring has slowed, America still boasts an unemployment rate of just 3.7 percent — a historically low level…
Inflation has been slowing for months. That means that even though rates today are exactly where they were in July, they’ve been getting higher in inflation-adjusted terms — weighing on the economy more and more.
Increasingly steep real rates could squeeze the economy just when it is showing early signs of moderation, and might even risk setting off a recession. Because the Fed wants to slow the economy just enough to cool inflation without slowing it so much that it spurs a downturn, officials want to avoid overdoing it by simply sitting still…
“Neutral” is the rate setting that keeps the economy growing at a healthy pace over time. If interest rates are above neutral, they are expected to weigh on growth. If rates are set below neutral, they are expected to stoke growth… Right now, officials think that the neutral rate is in the neighborhood of 2.5 percent. The Fed funds rate is around 5.4 percent, which is well above neutral even after being adjusted for inflation… [end quote]
The fed funds rate is a short-term rate that does impact some adjustable-rate bonds and preferred stock yields. Longer-term bond yields are impacted by market forces, including Treasury issuance and evidence of a stronger economy. The Treasury yield curve is rising. This is normal as the markets gain confidence in a “soft landing” in 2024.
Corporate bond yields have been fairly steady since the Covid recovery in 2022. They are much higher than the Fed-repressed Covid yields. Refinancing maturing loans will pressure corporate cash flows.
If the Fed continues to roll off its long-term bonds, I expect the longer-term yields to stabilize and not to follow the fed funds rate down when the Fed cuts. That will result in a normal, positive–sloped yield curve. That cyclical bond trend is a positive indicator for the stock market.