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Rates Rising in the Wake of Fed Rate Cuts
Just over a month has passed since the Federal Reserve’s rate cut on September 18th, and something unusual is happening in the Treasury markets. Despite the reduction in the benchmark rate, yields are continuing to rise across maturities. The U.S. 10-year Treasury yield recently hit 4.22%, its highest level since July, while two-year yields have climbed 34 basis points since the Fed cut rates, now sitting above 4% for the first time since August. Although this kind of reaction post-rate cut is uncommon, it’s not unprecedented.
A similar scenario unfolded in 1995, when the Fed, led by Alan Greenspan, managed to cool the economy and orchestrate a “soft landing”—a feat investors are hoping for today. Historically since 1989, two-year yields tend to drop after the Fed begins cutting rates, falling by an average of 15 basis points one month into a rate-cutting cycle. But in 1995, after three cuts (from 6% to 5.25%), the yields on 10-year notes rose more than 100 basis points within a year, and two-year yields jumped 90 basis points (chart below).
Source: Bloomberg
Why Are Yields Rising Now?
Several factors could be driving the recent rise in yields, but given the upcoming election and increasing market volatility, explanations must be considered cautiously. Both the VIX (equity volatility index) and the MOVE Index (fixed income volatility index) have risen in recent weeks, signaling heightened uncertainty (see chart below). However, two key scenarios offer insight into the potential drivers of this yield movement, each pointing to very different economic outlooks.
Source: TradingView as of October 23, 2024
Scenario 1: 1995 All Over Again
The most likely explanation for rising yields is the expectation of an economic soft landing, similar to 1995. In this scenario, rising yields reflect reduced recession risks. Unemployment remains low, and the International Monetary Fund (IMF) has recently revised its projections for U.S. GDP growth in the fourth quarter, estimating a 2.5% expansion—half a percentage point higher than its July forecast. This has led investors to believe the Fed might slow the pace of rate cuts more than previously anticipated. Currently, interest rate swaps suggest the market expects the Fed to lower rates by 128 basis points through September 2025, compared to 195 basis points priced in just a month ago.
This optimism is reflected in parts of the fixed income market. The ICE BofA U.S. High Yield Index’s option-adjusted spread has reached its lowest point since 2007 (chart below), indicating growing investor confidence. Narrowing spreads typically signal healthier financial conditions and a decreased concern over corporate defaults.
Scenario 2: Inflation Concerns on the Horizon
While the soft landing narrative is plausible, there are signs suggesting inflation could be a driving force behind rising rates. Despite a robust economy and record-high equity markets in 2024, gold prices have surged more than 30% this year, reaching an all-time high. This simultaneous rise in equities and gold is unusual.
Gold is often viewed as an inflation hedge, and its rise may indicate that investors are concerned about inflation making a comeback. Although inflation has been trending downward, this doesn’t necessarily mean the fight against price increases is over. If inflation reaccelerates, the Fed may be forced to keep rates higher for longer, or even raise them again. This could explain the recent uptick in longer-term rates, as well as the rally in inflation hedges like gold.
One factor contributing to inflation concerns is the growing cost of servicing the national debt, a situation that will worsen regardless of the election outcome. The Congressional Budget Office (CBO) projects interest payments will reach $892 billion in fiscal year 2024, with net interest costs expected to climb from $1 trillion in 2025 to $1.7 trillion by 2034. In total, net interest payments will amount to $12.9 trillion over the next decade, increasing from 3.4% of GDP in 2025 to 4.1% by 2034—surpassing the previous post-World War II high of 3.2% in 1991.
A rising national debt can stoke inflation by increasing government borrowing, which injects liquidity into the economy without a corresponding rise in productivity. This excess liquidity can push prices higher, especially if central banks finance the debt by expanding the money supply. Additionally, concerns over rising debt may undermine investor confidence, driving borrowing costs higher and potentially weakening the currency, both of which could further fuel inflation.
Impact on Equity Markets
While the inflation risks from mounting interest costs are a longer-term concern, they are unlikely to impact U.S. inflation gauges or the stock market in the immediate future. In the near term, corporate earnings from the third quarter will likely dictate equity market performance. So far, the results have been encouraging. As of October 18, 2024, 14% of S&P 500 companies had reported, with 79% delivering positive earnings surprises. The average earnings growth rate is 3.4% year-over-year, marking the fifth consecutive quarter of year-over-year growth for the index.
Conclusion
In the face of rising yields, investors are confronted with two very different potential outcomes—either a soft landing that signals continued economic strength or the return of inflationary pressures. While both scenarios offer valuable insights, the current market environment is marked by uncertainty. As we navigate these conflicting signals, it’s crucial for investors to remain nimble and adapt to changing conditions. Staying active and flexible in portfolio management can help mitigate risks and capitalize on opportunities, whether the economy continues on a steady path or is disrupted by unexpected inflationary forces. In times like these, a disciplined approach is essential.
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Definitions:
ICE BofA Merrill Lynch US Market Option Volatility Estimate (MOVE) Index is a widely recognized measure of U.S. interest rate volatility. Often referred to as the “VIX for Bonds,” it tracks the implied volatility of U.S. Treasury options across different maturities, including 2-year, 5-year, 10-year, and 30-year Treasuries. This index provides insights into market expectations of future interest rate movements and is a key indicator for bond market participants.