It has been puzzling many that the Federal Reserve has cut interest rates lately, yet Treasury yields have been rising. Traditionally, when the Fed cuts the rate, bond yields, especially longer-term Treasuries, decline because the cost of borrowing falls and economic activity is expected to be sluggish. But that’s the opposite of what’s happening in this scenario.
The first is the market’s expectation of future economic performance. Investors have become very optimistic about the ability of the economy to persevere and expect that inflation will remain heightened, thus requiring higher yields on long-term bonds such as the 10-year Treasury. As expectations of inflation increase, investors demand yields to be compensatory to the decreased purchasing power of future interest payments. The Fed’s forecasts, indicating further rate cuts in the future, are also an influence on how bond traders position themselves.
In addition to that, the market may be getting ready for an event in which the economy is actually supposed to avoid a recession, as data points are pointing towards strong growth and relatively stable inflation. This led to what some analysts portray as a “bifurcated” bond market: short-term yields have declined while long-term yields continue rising. The yield curve, having been inverted for more than a decade, is likely to normalise with the downward movement of Fed rates and shift back into its upward sloping configuration where yields on longer-term paper exceed those on short-term paper.
Another factor is the sustained high level of foreign appetite for U.S. Treasuries on account of their being a safe haven for numerous overseas investors. Meanwhile, a growing U.S. deficit and growing government borrowing to finance new spending could be forcing upward pressure on long-term yields, too. Since investors must perceive greater returns over longer periods in buying government debt because of growing anxiety about the fiscal sustainability of the U.S., that pressure continues to be felt.
A sharpish recent rise in Treasury yields suggests that the move may be in spite of a very recent Fed cut, pricing in higher inflation or future interest rate hikes. And this situation shows up the rather rich complexities at play in today’s business environment, yet badly inclined to ignore the traditional expectations about monetary policy and market response.
