What has the Fed been doing recently?
After holding rates steady for more than a year, the Federal Reserve (Fed) cut the federal funds target rate by 50 basis points (0.50%) in September, followed by 25 basis points (0.25%) at the next meeting in November. These moves brought the target federal funds rate to a range of 4.50%-4.75%, which is still elevated (or restrictive, to use Fed terminology) relative to historical averages and the yield on other fixed income securities.
Remember that the Fed’s job is to maintain financial stability in the economy by maintaining maximum employment while also keeping inflation at a moderate, predictable level. Since the US economy has been incredibly resilient, driven by strength in consumers and the labor market, and inflation has been trending lower, the Fed has determined it is appropriate to reduce the federal funds target rate at a gradual pace.[1] This describes the elusive “soft landing”, the ideal outcome of monetary policy that has rarely been achieved, where the Fed successfully slows down the economy enough to reduce inflation without causing a recession.
Of course, the actual path of interest rates will depend on how the economy continues to evolve. Let’s discuss a couple of alternative scenarios to the soft landing:
Hard Landing: Economic conditions deteriorate (e.g., significant rise in unemployment, slowdown in growth) or economic shock (e.g., unexpected financial crisis, natural disaster, geopolitical escalation)
A hard landing could throw the US into a recession, causing the Fed to reduce interest rates aggressively as it attempts to stabilize the economy. Expected reactions would be a pullback in risk assets, a flight to safety in US Treasuries (moving yields lower), and potentially deflation.
No Landing: Acceleration in growth and inflation
A pro-growth environment is likely to lead to rallies in areas like small US companies, banks, and US manufacturers but could also lead to a resurgence in inflation and drive the deficit higher. The Fed may be required to change paths again to combat higher inflation, leaving interest rates at current levels or returning to rate hikes. Bonds and rate-sensitive equity sectors would be negatively impacted in this scenario.
Note: While the soft landing remains our base case, we believe the potential likelihood of this scenario has increased since the election, which we will discuss in further detail below.
What is the Fed planning to do now?
While the Fed always painstakingly emphasizes data dependence and a meeting-by-meeting decision making progress, it releases a quarterly “dot plot” that shows each Fed participant’s individual projections. The most recent forecast released by Fed participants was in September, and the “dot plot” median showed another 25 basis point cut expected in December but just four cuts over eight meetings in 2025. The pace of easing has already slowed, and traders have long suspected the Fed to downshift again to an every-other-meeting, 25 basis point pace. In other words, the Fed currently expects the “soft landing” scenario in which it will be able to gradually reduce the target federal funds rate over the next couple of years.[2]
So, if the Fed is cutting, why are rates moving higher?
As shown in the graph above, the move in Treasury rates since the Fed began its interest rate cutting cycle in September has been somewhat counterintuitive, with yields across the board declining in anticipation, then moving steadily higher in October and November. It is also notable in the chart above that the fed funds (short-term) rate is still above the 10-year rate, which has been true for the last two years or so but is not what you expect to see in a “normal” environment.
So, if the Fed has executed 75 basis points of interest rate cuts so far and is communicating more to come, why are interest rates moving higher? The question is more complex than it may seem on the surface, and the answer may be the favorite, go-to response from economists: “it depends.” Does the Fed really control rates? To answer that, we need to first define what we mean by “rates”, as the term encompasses a wide range of potential securities with different drivers.
For comparison, consider if someone asked, “What does this event mean for stocks?” Are they interested in the impact on large technology companies? Utilities? International companies? The answers to each could vary widely, just as they do within the diverse bond market.
In this piece, we will focus primarily on the Fed and how it influences high-quality US securities. We will explore the distinction between short-term rates and long-term rates, discussing the key drivers of each. Understanding these nuances helps explain why rates might move higher even as the Fed signals more reductions to come.
How does the Fed influence interest rates?
The Fed influences interest rates through its monetary policy tools, primarily by setting a target range for the federal funds rate, the interest rate at which banks lend reserves to each other overnight. This directly affects short-term rates, such as Treasury bills (with maturities of 1 year or less), money market rates, and commercial paper. These very short-term instruments are the only yields immediately impacted by a change in the fed funds rate. This is not to say that Fed decisions don’t impact other areas of the curve because they certainly do. Still, longer-term yields are tied to the expectations of future Fed activity and long-term market and economic projections. It is a complicated dynamic, and even Fed Chair Powell has referred to monetary policy as a “blunt object, not capable of surgical precision.”[3]
The short end of the yield curve is most sensitive to Fed policy changes.
The long end of the curve reflects broader market expectations, including inflation, growth, and risk sentiment.
Why does Fed policy impact parts of the yield curve differently?
The short end of the yield curve (short-term interest rates roughly 2 years and shorter) is most sensitive to Fed policy, especially changes in the federal funds rate. Here's why:
Rates for securities such as floating rate notes, Treasury bills, and money market rates are directly linked to the fed funds rate.
The 2-year Treasury yield closely tracks market expectations for the federal funds rate over the next two years. When the Fed raises or signals higher interest rates, the 2-year yield typically increases because investors adjust their expectations for future short-term rates. Conversely, if the Fed signals rate cuts, the 2-year yield tends to decline.
As financial markets attempt to predict the future and tend to overshoot in both directions, expectations for Fed activity can swing wildly and tend to be more volatile than the Fed itself.
The long end of the yield curve (long-term interest rates, such as 10-year and 30-year Treasury bonds) is less directly influenced by Fed policy yet has one of the biggest impacts on the average household since it is a significant driver of borrowing costs, mortgage rates and housing affordability. Long-term rates aren’t typically tied to the fed funds rate and are more sensitive to:
Inflation Expectations: If investors believe inflation will rise, they demand higher yields on long-term bonds.
Economic Growth Outlook: Strong growth prospects can lead to higher long-term rates, while fears of a slowdown or recession often push them lower.
Global Demand for US Treasuries: International investors, central banks, and institutional investors heavily influence long-term yields. A large and rising deficit could raise concerns about the sustainability of excessive government spending.
What has changed since the 2024 Presidential Election?
While the market will continue to digest election results and implications for months to come, the initial reactions to President-elect Trump’s victory combined with Republican control of Congress have been a rally in pro-growth sectors that could benefit from the extension of corporate tax cuts and deregulation like small US companies, banks, US manufacturing, and onshore energy producers. A reacceleration in growth, combined with the potential proposed tariffs and changes in immigration policies, could also prove to be inflationary. As it relates to the bond market, here are a few of the factors that may be driving long-term rates higher in reaction to President Trump’s election:
Pro-growth policies and tax cuts are designed to stimulate economic activity, which may disrupt the supply/demand balance and lead to inflation in an economy that is already at or near full employment.
Immigration contributes to the labor force, often filling gaps in industries that face labor shortages. A decrease in the workforce can lead to tighter labor markets, increasing competition and wages (good for workers, but increases in costs to businesses are typically passed on to consumers in the form of higher prices, contributing to inflation).
Tariffs are intended to protect domestic industries and punish foreign countries for committing unfair trade practices, and they have been a tool used by both political parties. The net impact of tariffs themselves is difficult to predict from an economic perspective, but a dramatic increase could lead to inflation to the extent that other countries may retaliate, production costs may increase (and be passed on to consumers), or supply chains could be disrupted.[4]
Inflationary policy impacts may be offset if the new administration successfully increases government efficiency and reduces unnecessary spending.
As described above, the long end of the yield curve is heavily influenced by inflation and growth expectations, which is why we are seeing long-term yields increase even as the Fed plans to continue reducing the fed funds target rate. Inflation continues to moderate, but the pace has slowed more than the Fed would like over the last several months as the core items like housing prices have proven difficult to bring down.[5]
Bottom Line
The Fed is trying its best to remain apolitical and will remain squarely focused on the economy as it determines the path of short-term interest rates. At this stage, consumer spending and a strong labor market continue to drive the resilient US economy, and we expect the Fed to continue gradually cutting the federal funds rate while keeping a close eye on inflation. The longer end of the yield curve may remain elevated near current levels, leading to a positively sloping yield curve, which is healthy for a “normal” economy.
Higher inflation and a rising deficit are risks for 2025 and beyond, which has the potential to take long-term rates another leg higher. To end on a positive note, higher rates benefit savers who can continue to earn 4-5% on low-risk assets like US Treasuries, certificates of deposit, and investment grade corporate bonds. Relatively attractive yields are also good news for investors who can once again use fixed income in portfolios for diversification, income, and stability.
[2] Bloomberg, FHN Financial
[5] Chart source: JP Morgan Guide to the Markets as of November 13, 2024
Important Disclosures
Forecasts regarding the market or economy are subject to a wide range of possible outcomes. The views presented in this material may prove to be inaccurate for a variety of factors.
Please note: ChatGPT was utilized in the efforts to create this article. ChatGPT is a widely available artificial intelligence tool. In this case, ChatGPT was used for the purposes of confirming research sources and structuring the article for drafting purposes. The actual written product is from our firm’s professionals.
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