Three months ago, in the week before the Federal Reserve’s first rate cut in the current cycle, the bond market was pricing in a two-year yield of 3.58%.
The two-year yield has since risen to 4.23%, an increase of 65 basis points at a time when the Fed is cutting interest rates.
Two-year yields are regarded as market expectations of Federal Reserve policy, with the increase suggesting a more cautious approach to monetary policy by the Fed.
It’s not just short-term yields that have risen, though. Five-year yields have increased by 81 basis points since Sept. 13, and 10-year yields have gone up by 73 basis points.
At the far end of the curve, 30-year bond yields are 60 basis points higher, increasing from 3.98% to 4.58% in mid-December.
Normally, yields would be expected to fall at a time when the Fed is cutting rates. But uncertainty over the strength of the economy and the probability of inflation’s decline stalling at 2.6% to 2.8% have helped push up yields.
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Higher yields for longer duration bonds suggest the market is requiring higher compensation for the risk of the shift in Fed policy and, moreover, for the uncertainty over the direction of fiscal policy and debt accumulation over the next four years.
While we do not anticipate that today’s meeting of the Federal Open Market Committee will end that uncertainty, we should see the Fed move in a direction that aligns its forward-looking communications with market expectations.
Next year will most likely have notable revisions to the Fed’s forecast and market expectations of where the Fed‘s neutral rate will land.
