05 Aug Fed signaling interest rate cuts – a harbinger of sharply lower interest rates across the yield curve? My reading is “not so fast”
In his comments on July 31, 2024, US Federal Reserve Chairman Jerome Powell emphasized the need for more evidence of sustained progress before considering interest rate cuts despite signs of easing inflation. The Fed’s cautious approach, stating that it is data-dependent, is a key factor to consider in the current economic climate.
Bond prices rallied across the yield curve since the end of the second quarter of 2024, anticipating imminent rate cuts this year by the Fed. For instance, the yield on the ten-year notes dropped approximately thirty-nine basis points since June 28, 2024, from 4.36% to 3.97% to now. Similar drops in rates were observed across the yield curve during this period.
The bond market action now begs whether the Fed largely won the fight over inflation and whether the bear market in bond prices that investors suffered since 2021, when the Fed started its inflation fight by sharply spiking the short-term rates, is now behind. Before reaching such an important conclusion on the bond yields, investors must further examine the factors still at play in the US economy. This thorough examination will ensure that investors are well-informed and knowledgeable about the current economic landscape.
The recent rally in bond prices, driven by expectations of future rate cuts, may not align with the Fed’s cautious stance. This divergence could lead to market misinterpretation and potential volatility if the Fed does not cut rates as expected. It’s important for investors to be aware of these risks.
Inflation and Consumer Spending: Although the rate of price increase (otherwise known as inflation) has moderated during the past twelve months, consumers are now faced with substantial increases in food, shelter, and services such as childcare, which show no signs of abatement. For instance, the Core Personal Consumption Expenditure Index (excluding the volatile food energy prices) remains at 2.6% as of May 2024. While wages went up adjusted for inflation since the Pandemic, they have largely been consumed by increases in the cost of living across the board. Consumers are struggling to balance their budgets and are downgrading their lifestyles to make ends meet.
Federal budgets and deficit spending: The Congressional Budget Office (CBO) projects the U.S. federal budget deficit for fiscal year 2024 to be approximately $1.9 trillion. The deficit is expected to increase over the following years, reaching about $2.0 trillion in 2025, $2.1 trillion in 2026, $2.2 trillion in 2027, and $2.3 trillion in 2028. These projections reflect a growing gap between government spending and revenue, driven by increased interest payments on the national debt and higher spending on mandatory programs like Social Security and Medicare. Even though the Fed’s tight monetary policy stance is supposed to damper the US economic growth rate, it has mostly been offset by federal deficit spending since the COVID-19 pandemic.
US Economic Growth Rates and Recessionary Forecasts: Economists and pundits have been forecasting an imminent recession since the end of 2021, mostly based on the Fed’s rate hikes. However, US consumer spending proved far more resilient than expected, and corporate earnings improved substantially, driving stock prices to new levels. This economic expansion largely owes its performance to the federal budget deficits and government programs subsidizing large swaths of the economy. Thus, any future recessionary forecasts must consider the deficits that prop up the economy ad infinitum.
Federal Debt driven by deficit spending: The U.S. federal debt is projected to reach approximately $33.3 trillion by the end of fiscal year 2024. Over the following four years, the debt is expected to increase as follows:
2025: Approximately $34.7 trillion
2026: Approximately $36.3 trillion
2027: Approximately $37.9 trillion
2028: Approximately $39.6 trillion
These projections are based on current fiscal policies and economic conditions, with debt levels expected to exceed 100% of the U.S. GDP during this period (Source: Bipartisan Policy Center). These levels of projected federal spending will likely lead to the issuance of approximately $6.0 trillion of new treasuries that the investors must absorb in the next five years. This relentless paper supply will likely put upward pressure on the yield curve before the bond markets achieve sustainable price equilibrium. This expansion in government borrowing could lead to higher interest rates as investors demand higher yields to compensate for increased supply and potential inflation risks.
Central Banks and Negative Real Interest Rates:
before the onset of the Pandemic – 19, major central bankers around the world, including the US Fed, lamented the low inflation rates for the decade that ended December 31, 2019, and proposed a “Modern Monetary Theory” that flooded the developed economies with liquidity by driving inflation-adjusted interest rates across the yield curve into negative territory. Approximately 20 trillion dollars of government debt yielded real negative interest rates during the decade. With the onset of a global inflationary wave, these bankers have abruptly changed their tune. For instance, they have now sworn inflation fighters again, abruptly switching from a decade-long Quantitative Easing strategy to a Quantitative Tightening role in 2021. This role reversal has resulted in massive losses for the holders of the debt issued during 2010 – 2019.
Conclusion:
Based upon various economic factors in the US economy, I believe that bonds are likely to yield real positive interest rates across the yield curve for the foreseeable future and that the bond prices are likely to be range-bound. It is hard to imagine circumstances during which yields on long bonds are likely to revisit the depths attained during the COVID-19 pandemic. A downside risk to this analysis is an unprecedented eruption of geopolitical tensions in the Middle East and Russia, aided by China. This could result in trade disruptions and a global economic slowdown. Diversification among asset classes and focus on the availability of liquidity in one’s portfolios could help soften the blow of such black swan events.
