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The Federal Reserve is benefiting from the favorable performance of bond yields in keeping inflation in check. However, it is now posing challenges for the central bank.
The abrupt surge in long-term US Treasury yields in recent months has caused distress for investors, resulting in a decline in many of their portfolios. Moreover, it has led to increased borrowing costs for the government.
Notwithstanding their benefits for the Fed, increased production has put pressure on Fed officials to take action before the meeting, offering new data and presenting a more comprehensive view of the current state of the economy.
Bond yields, particularly the yield on the 10-year Treasury note, influence interest rates on credit cards, mortgages, and auto loans. As rates escalate, borrowing money becomes more costly. Similar consequences occur when the Fed raises interest rates.
Following this month’s meeting, Fed Chairman Jerome Powell stated in a press conference that he was unable to explain the recent surge in yields. However, he emphasized that the higher Treasury yields results in increased borrowing costs for households and businesses, which will impede economic activity should the tightening persist.
Apart from Powell, several other Fed officials have also indicated that the Fed might refrain from further rate hikes in upcoming meetings if yields continue to remain high.
St. Louis Fed Interim President Kathleen O’Neill Pesce expressed support on Thursday for the Fed’s decision to maintain rates at its November meeting due to the tightness of financial and credit conditions that ensued over the past two years. He noted that this condition is reflected in the heightened yields on long-term Treasuries.
However, the issue remains that yields have not demonstrated stability.
Just before Powell’s comments following the meeting, bond yields declined subsequent to the Treasury Department’s quarterly refund announcement, surprising investors as the Treasury indicated a slightly reduced amount of debt to be auctioned compared to their expectations. Furthermore, Powell’s comments convinced Wall Street that the Fed has concluded its interest rate hikes, even though he did not state it explicitly.
John Madziire, head of U.S. Treasuries at Vanguard, remarked that Fed officials “will always give themselves optionality and therefore will never signal that rate hikes are over, especially given the growth data and the strength of the labor market.”
The Fed’s recent statement, stating that “financials” in addition to credit conditions were contributing to slowing the economy, “indicated that the market has done some work for the Fed,” according to macro strategist Joe Kalish from Ned Davis Research.
As a result, the yield decreased even further. From October 19 to November 8, the yield on the 10-year Treasury note decreased from approximately 5%, the highest level since 2007, to about 4.5%.
This effectively constituted a rate cut, marked by a swift drop in mortgage rates last week, the most significant decline in a year. Low mortgage rates are particularly unfavorable at a time when the Fed is striving to reduce inflation to its 2% target while also grappling with the risk of overheating in the economy.
However, some investors perceived the situation differently, as indicated by Kalish. He found comfort in the Fed’s decreased inclination to “further tighten the economy and push it into a recession.”
In a note on Friday, Bank of America economists underlined the predicament faced by the Fed, stating, “This puts the Fed in a tight spot.”
This elucidates Powell’s effort to dispel the perception among investors that the Fed has overextended.
At a conference in Washington, D.C., hosted by the International Monetary Fund, Powell explicitly stated, “We know that ongoing progress toward our 2% target is not assured: Inflation has given us some mistakes to make.” He further asserted, “If it becomes appropriate to tighten the policy further, we will not hesitate to do so.”
This instantaneously led to a rise in yields and ended the S&P 500’s prolonged streak of daily gains, dating back to 2004, as more investors started anticipating a rate hike at the Fed’s final meeting of the year.
“Going forward, it may be that a large portion of the progress in reducing inflation will have to come from tighter monetary policy,” Powell remarked. This contrasts with allowing bond yields to regulate the Fed’s operations.
Economists at Bank of America highlighted the imperative for the central bank to “acknowledge the cyclical relationship between fiscal tightening and its response to fiscal tightening.” In essence, the Fed will be required to exercise caution to avoid undoing financial tightening in the bond market by signaling to investors that this is an alternative to a rate hike.