As the Fed Cuts Rates, Treasury Yields Are Rising
With last week’s rate decision, the Federal Reserve has now cut the federal funds rate by 75 basis points over the past eight weeks. Over that same period, the 10-year Treasury yield has increased by 79 basis points – including 21 basis points as election results came in. This suggests that markets may expect stronger economic growth, higher inflation, more debt, or some combination of the three. High interest rates are both caused by and causes of a high and rising debt, and lawmakers will need to reduce deficits to prevent debt from spiraling out of control.
After holding the federal funds rate target range at 5.25 to 5.50 percent for over a year, the Federal Open Market Committee (FOMC) cut the range by 50 basis points to 4.75 to 5.00 percent in mid-September and by another 25 basis points to 4.50 to 4.75 percent in early November. As expected, yields on short-term Treasury bills fell in kind, with the 3-month yield dropping from 4.87 percent on September 16 to 4.54 percent today. But surprisingly, longer-term yields moved in the opposite direction of the federal funds rate, with the 10-year Treasury yield rising from 3.63 percent on September 16 to 4.42 percent today.
This increase was likely driven at least in part by a more bullish economic outlook. After economic data showed unemployment in July spiked to 4.3 percent, many commentators were predicting a recession (and the day of that employment data, the 10-year yield fell by 19 basis points). Since then the unemployment rate has subsided to 4.1 percent, and other strong economic data suggested recessionary fears were probably overblown. This, plus strong productivity estimates, signals to markets that the Federal Reserve is likely to cut rates more slowly and less deeply than might otherwise be the case.
Higher inflation expectations are also likely to blame for some of the rise in yields. The core personal consumption expenditure (PCE) price index has remained at 2.7 percent since July, well above the Federal Reserve’s 2 percent target. To the extent investors believe this inflation will persist, they are likely to demand higher nominal yields to compensate for inflation and may expect higher real rates as the Fed works to keep inflation at bay.
High yields may also reflect expectations of a high and rising national debt. With debt projected to grow by more than $22 trillion over the next decade under current law and lawmakers considering trillions of additional borrowing, higher interest rates may be necessary to attract sufficient demand for a growing supply of debt. And with debt projected to set a new record as a share of the economy and rise indefinitely from there, some investors may even question the risk-free status of Treasury securities and demand additional yield to compensate for new risks. As yields climb higher, the resulting larger interest payments can put further strain on the debt load.
The recent rise in yields has likely been exacerbated by the election and the fiscally irresponsible proposals by both presidential campaigns. As both candidates continued to add deficit-increasing proposals to their campaign agendas, yields rose. And the 10-year yield increased significantly by 21 basis points as election results came in, from the time polls started closing to when the election was called. (The 10-year yield has since fallen by 5 basis points, mainly due to the Fed announcing a 25-basis point cut).
The election day surge could reflect a belief that the election outcome will lead to stronger economic growth, more inflation, additional debt, or some combination of the three. We previously estimated that President Trump’s agenda could increase debt by $7.75 trillion over a decade, if enacted in full, which might help explain the rising yields.
Rising interest rates are both a cause and consequence of having a large and growing national debt. Literature has shown that high debt pushes up interest rates. But high interest rates also boost interest payments, leading to even higher debt. If not addressed, this could eventually lead to a debt spiral and perhaps a fiscal crisis. The U.S. Treasury market is not impervious to declining investor sentiment on the nation’s fiscal trajectory, and it’s possible that “bond vigilantes” cause a yield crisis sooner rather than later.
