Investors expect the Federal Reserve to cut the federal funds rate and signal a series of further cuts through next year at its next meeting on Sept. 18.
We are updating our year-end rate call to 3.7% on the 10-year yield with risk of a move lower as growth, inflation and hiring cool.
Those expectations have 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 4.0% to 4.5% trading range since January.
This stands in contrast with the 4.21% average for the year and our 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 with risk of a move lower as growth, inflation and hiring cool.
The market is doing the Fed’s work as investors front-run the first rate cut. 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 cut rates, but when, and by how much.
How long?
How long should senior executives wait before acting on delayed investment decisions?
Businesses, after all, must achieve a return on invested capital more than their weighted average cost of capital. As the WACC falls, firms will increase capital expenditures, which will bolster overall growth.
The next question, then, is how long financial market participants need to wait before taking profits on bond holdings?
A new paper by the Bank of 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.
Conversely, you would expect longer-term securities to incorporate expectations for the health of the economy.
Read more of RSM’s insights on financial conditions, the economy and the middle market.
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 disfunction between 2009 and 2020.
In recent weeks and months, however, we attribute the negative term premium to the risk that the Federal Reserve has 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, the negative term premium has resulted in 10-year bond yields closely tracking 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 3.0% to 3.5% next year.
Were the effect of government investment in infrastructure and the private-sector’s investment in productivity 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.
We also expect the Fed to gradually lower the federal funds rate by 25 basis points at each meeting in the near term, though there is chance of larger cuts, by 50 basis points, should the labor market deteriorate. Such a reduction would exert downward pressure on short-term rates while helping to maintain stability.
We would argue that cutting the funds rate by more than 25 basis points, at a time when inflation remains above the Fed’s 2% inflation target, might signal distress, causing investment and spending to pause, thereby defeating the purpose of the rate cut.
The rate cuts and the removal of recession risk imply the term premium returning to moderately positive values in the near-term.
This return to positive values would occur as short-term rate expectations are being lowered, moderating the decline in yields once the initial frenzy 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 indicate a range of outcomes.
The first model estimates the lagged 10-year yield of 3.75% as the sum of expectations of the short-term rates of 3.95% plus a still negative term premium of minus-0.21%.
The second estimate of 3.71% 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 1.67% plus the implied value of inflation compensation of 2.04%.
This model adds confirmation of the market pricing in the Fed cutting rates at its next meeting.
The third estimate posits that in the long run, 10-year bond yields at 4.3% would reflect the economy growing at current estimates of its potential growth rate of 1.8% per year, plus a de facto inflation target of 2.5% per year.
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 higher rates and 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 will end up in two years and economic growth.
Because the two-year Treasury bond yield is determined as the present value of the federal funds rate over the next two years, we can assign the current 3.65% two-year yield as indicative of the federal funds rate falling from its current level of 5.5% to less than 3.65% over the course of two years.
That decline coincides with our forecast of a terminal federal funds rate in the range of 3.0% to 3.5%.
Because the current 10-year yield of 3.71% is now higher than both the two-year and five-year yield, the newly re-established upward sloping yield curve suggests a normal financial system generating appropriate returns on short and long-term investments.
The last section of this financial framework provided by the bond market will be put in place over the next two years as the Federal Reserve pressures money market rates lower.
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 outsized 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 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 August 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 July’s 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 11.7% average annual returns of the S&P 500 over thepast 15 years.
Credit spreads
Since peaking in 1982, the long-term decline in investment-grade (Baa) credit spreads has been broken only during the major disruptions to the business cycle.
So far, and assuming the Fed will begin to ease its policy rate, the turmoil stemming from the yen carry trade remains a blip compared to bigger meltdowns and loss of confidence.
Still, it is symptomatic of the concern within the markets that the Fed may have missed its chance for a soft landing of the economy.
Financial conditions remain 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 with a healthy, though cooling, labor market.
In the weeks before the Fed’s September meeting, the three components of the RSM US Financial Conditions Index were all negative.
- Conditions in the money markets turned negative at the end of August and beginning of September but remain close to neutral.
- Conditions in the equity market turned slightly negative in this past week for the first time since the end of last year.
- The bond market’s inverted yield curve has consistently indicated excess amounts of economic risk since the Fed began tightening monetary policy in March 2022.
The negative readings add up to the RSM US Financial Conditions Index holding at 0.6 standard deviations below normal, with support from the equity market no longer propping up the index.
Our index was formulated to anticipate the willingness of banks to make loans to businesses as well as anticipating economic growth.
The current tepid level of financial conditions suggests the lingering impact of a higher cost of credit on both the lenders and borrowers. While the economy is now growing at a 2.9% annual rate, there is no doubt that rate cuts will 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 both 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
We expect the Fed to join other central banks among the developed economies (with the exception of the Reserve Bank of Australia) that have already begun lowering their policy rates.
Even then, the U.S. bond market will continue to provide the highest return to foreign investors.
In addition, the growth of the U.S. will support those higher interest rates,
Finally, the adherence to the rule of law guarantees the safety of investment in U.S. companies.
The attractiveness of U.S securities seems evident in the upward trend on foreign purchases of U.S. Treasury bonds and notes.
