The 10-year yield has only increased in tandem with rate cuts twice since the early 1980s, and this is mostly due to growing inflation expectations.
The 10-year Treasury yield has increased by roughly the same amount as the Federal Reserve has lowered interest rates over the same time period, which has reportedly only happened twice in the bond market since the early 1980s and has stock market investors on edge.
When the central bank started reducing rates by a full percentage point over three months in mid-September, the widely followed benchmark rate, BX:TMUBMUSD10Y, which affects the cost of borrowing on everything from corporate bonds to mortgages and auto loans, dropped as low as 3.6% before rising to 4.77%. Stated differently, the 10-year yield has increased by a little more than the total amount of the Fed’s three rate decreases from September to December.
As has been the case during the majority of Fed easing cycles since 1989, long-term rates on U.S. government debt typically decline in the 200 days prior to and following the central bank’s rate-cutting actions, which helps to improve financial conditions by making borrowing easier. According to data provided by Torsten Slok, chief economist at Apollo Global Management in New York, the 10-year yield surged by less than a full percentage point, or less than it has today, in the few instances where this did not occur.
“The market is telling us something, and it is very important for investors to have a view on why long rates are going up when the Fed is cutting,” Slok stated this week. Whether the extremely unusual bond-market movements are due to concerns about the U.S. fiscal position, a decline in foreign demand for U.S. government debt, or a belief that the Fed’s 2024 rate cuts were unwarranted are some of the issues that people should be asking, he added.
In addition to a University of Michigan survey that indicated increased consumer expectations for future price hikes, Friday’s surprisingly robust employment gains of 256,000 for December brought the prospects of higher inflation back into the forefront of market participants’ minds. With the Dow Jones Industrial Average (DJIA) dropping nearly 700 points, U.S. stocks saw a steep sell-off. In the meantime, 10- and 30-year BX:TMUBMUSD30Y Treasury rates reached 14-month closing highs due to a vigorous bond selloff.
The December consumer-price index, which is released on Wednesday, is the next significant report on U.S. inflation for the coming week.
The 5-, 10-, and 30-year breakeven rates—market-based projections of future inflation—rose to their highest levels since last April or May over the course of the last week, edging closer to the Fed’s 2% target. Even as they delivered their third and final rate cut of 2024, the central bank’s most recent meeting minutes in December revealed that nearly all policymakers saw increased upside risks to inflation. The fed-funds rate target ended the year between 4.25% and 4.5%, down from a previous 16-year high of 5.25% to 5.5%.
According to former hedge-fund portfolio manager Guy Haselmann and portfolio manager Brian Mulberry of Chicago-based Zacks Investment Management, the bond market’s odd movements suggest that inflation could resurface. Furthermore, they warned that any decision by incoming President Donald Trump to impose mass deportation and tariff measures might push real inflation and expectations for future price hikes considerably higher in the near future.
“Inflation is clearly recovering, bouncing, trending up – however you want to phrase it,” Mulberry stated over the phone at the moment. He referenced the three-month annualized core rates for the October through December personal-consumption expenditures price index, the Fed’s preferred inflation indicator, and the CPI. Each of them came in at or above 3%, according to Mulberry, whose company manages assets worth about $20.4 billion.
The bond market is a reflection of the fact that it is too soon to declare inflation to be over. For the time being, the Fed’s easing cycle is likely coming to an end, but there is still a lot of work to be done,” he stated. This indicates that interest rates will remain at about 4% for the foreseeable future. If the Fed were forced to hike rates, it would be an admission of error and the worst-case scenario since the equities market hasn’t priced that in at all.”
Investors have been aggressively selling off 10-year government notes, as well as 20- and 30-year Treasury bonds, in recent months, which has caused rates on all three to rise toward 5%. A temporary recurrence of the 10-year yield’s October 2023 brief breach of 5% is viewed as a potential buying opportunity for investors who do not currently own the underlying government note.
Investors must be ready for a period of stock market volatility when interest rates are high. A higher cost of capital than previously believed has a tendency to erode valuations for small and midsized businesses, consumer discretionary brands, and the growth sector. The inability to participate in as many IPOs or mergers and acquisitions as anticipated may also have an effect on banks. Due to the comparatively steady demand for necessary services, utilities are typically more immune to stock market selloffs.
When the Fed began lowering interest rates, the 10-year yield last increased by roughly the same amount in 1981.
Under the direction of then-Chair Paul Volcker, the Fed tightened the money supply in late 1980 and early 1981, allowing the central bank’s primary interest-rate objective to reach an all-time high of nearly 20%. In order to counteract excessive inflation and counteract the recession brought on by their own policies, officials had been gently adjusting rates up and down during 1980 rather than steadily in one direction.
According to records of the Fed’s board in Washington, officials reduced interest rates by 4.5 percentage points between mid-January and mid-October 1981, from 19% to 20%, or 14.5% to 15.5%. However, these reductions were made in an up-and-down fashion.
During those months, an extremely unusual event occurred: the Treasury yield increased by about 4 percentage points, from around 12% at the beginning of the year to an all-time high of just over 15.8% in September 1981. Interest rate movements continued to fluctuate in the subsequent year, 1982.
A number of factors can typically impact the direction of Treasury yields, according to Haselmann, a former analyst with Scotiabank in Toronto who currently serves as a consultant. However, when the 10-year rate increases as much as it has following the Fed’s rate-cutting stance, “it’s all about inflation expectations.” The Federal Reserve’s “only explanation for what’s occurring now is that the marketplace has inflation expectations that are rising,” putting the Federal Reserve “in a quagmire.”
“Some people may cite a large fiscal deficit and Treasury supply for rising rates, but those were known variables when the 10-year was at 3.6% before the first rate cut – so that has some influence, but is not the catalyst for the 100-basis-point-plus increase,” according to MarketWatch.
“Inflation is not controlled yet and the expectation remains that the Fed is not going to be able to achieve its 2% mandate in the near future,” Haselmann stated by phone. When inflation expectations are growing and the Fed is aggressively reducing rates—as it did in September with a 50 basis point decrease and again in November and December with a total of another 50 basis points—”that is directly manifesting itself in the long end of the Treasury curve.”
Additionally, he stated: “I believe that the Fed will exercise tremendous patience in either direction this year. To put it another way, I wouldn’t be shocked if the Fed made no cuts in 2025. Additionally, I should add that even if inflation continues to climb, I don’t necessarily think the Fed would hike because higher rates and inflation will both operate as economic headwinds. Self-correcting mechanisms are inherent in the market. Additionally, the equities market will start to adjust down to more reasonable valuations after being fully priced for a favorable economic scenario.
In the first half of this year, he believes there is a chance that the 30-year yield will surpass 6% and the 10-year rate will touch 5%, which may draw a “ton of buyers.” The portfolios of investors will need to be “a little safer and less aggressive to weather a lot of different storms, including increased volatility.”
Numerous other theories have been put up to explain the current state of the bond market. The “historical anomaly” of a 10-year yield that has increased by the same amount as the Fed has decreased rates over the same time period, according to Nicholas Colas, co-founder of DataTrek Research, translates into still respectable growth, in his opinion. The market may be adding in a “insanity” premium to account for the “crazy things” that Trump has stated about economic policy, according to Nobel-winning economist Paul Krugman.
The most significant data event of the next week is probably the December CPI report, which is released on Wednesday.
The NFIB Small Business Optimism Index, the Federal Reserve’s Beige Book report, and the producer-price index for the previous month are all scheduled to be released on Tuesday. The January Empire State and Philadelphia Fed manufacturing surveys, the home-builder optimism index, and business inventory statistics are all scheduled for release on Wednesday.
