Something seems off. So, the Fed lowered rates last month… why are interest rates higher? And not by a little. The 10-year Treasury rate rose to 4.23 % after moving 61 basis points in a little more than a month since the Fed lowered the target Fed Funds rate by 50 basis points. If it seems confusing and counterintuitive, we would agree on both counts, but more context may help to understand the recent move higher in rates.
Source: FactSet
The Federal Open Market Committee has a dual mandate in its role in setting monetary policy. Their work is aimed toward both stable prices and full employment. The committee started acting in 2022 to combat high inflation by raising rates. As inflation started moving lower, the Fed kept rates high in order to avoid an inflation resurgence. As we moved through this past summer, the market consensus began pricing in that the Fed would initiate a cutting cycle in September as inflation seemed subdued and moving steadily toward the Fed’s stated 2% target and the labor market had softened on the margin.
That all makes logical sense. But the benchmark 10-year Treasury rate has been moving in the opposite direction lately, and there are a few key reasons behind this counterintuitive move.
First, the market now anticipates a more dovish Fed going forward. The 10-year Treasury rate made a temporary low on September 16, not so ironically the day before the two-day FOMC meeting started. On September 19, the market was pricing in 57.2% odds of Fed reducing its target rate to 2.75% or lower by the October meeting next year. Today, the market is pricing in 67.9% odds of the Fed reducing its target rate only to 3.50% or higher by the October meeting next year. The market is pricing in a more dovish Fed than it was the day after the meeting, which would result in rates higher for longer. But why?
Remember that pesky dual mandate? Well, data has come in since the Fed meeting to indicate that inflation last month was stickier than was expected with the September CPI report. Also, the September nonfarm payrolls report exceeded expectations indicating that the labor market is handling tighter monetary policy better than expected. One datapoint does not indicate a trend, but inflation remaining stubbornly above target and the jobs market exhibiting resilience would together suggest that the Fed has more room to be patient with rate cuts. And that is what the market is assuming with rates moving higher.
The direction of monetary policy is not the debate occurring in the bond market. It has been clear for some time that the Fed would be lowering the Fed funds rate as the inflation rate approached their target. However, the trajectory of cuts is under debate as more or less urgency on the part of the Fed comes with certain implications for the broader economy.
Also, it's important to remember that the FOMC sets a target for the federal funds rate, which influences rates throughout the economy. However, it does not control longer-term interest rates, and especially the 10-year Treasury rate. Buyers and sellers set the prices of the 10-year Treasury while taking in all available data including the federal funds rate and the anticipated path of monetary policy.
So, if there seems to be a disconnect between what the Fed is doing and what the market is doing, that is absolutely the case… by design.
By J. Keith Buchanan, CFA, Senior Portfolio Manager.
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Source: CME Group, FactSet
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