In a surprising turn of events, the Federal Reserve seems to be changing its course. Despite recent employment and inflation data suggesting a potential interest rate hike in November or December, Fed officials have been actively downplaying the likelihood of such a move. This shift in sentiment is largely attributed to the bond market’s impact on the central bank’s decision-making process.
Over the past week, we witnessed the usual inverse relationship between bond yields and stock prices in action. After steadily climbing to a nearly 5% yield on the 10-year U.S. Treasury note and consequent downward trends in major stock indexes in recent weeks, the tides turned. Yields decreased, and stocks experienced a small rebound.
By the end of the week, the S&P 500 index saw a 0.45% increase, the Dow Jones Industrial Average rose by 0.79%, and the Nasdaq Composite slipped slightly by 0.18%. Simultaneously, the 10-year yield fell by 0.16 points, settling at 4.63%.
The catalyst for this reversal was a series of speeches by Fed representatives acknowledging that the surge in bond yields had tightened financial conditions significantly. Consequently, borrowing costs for businesses, consumers, and even the U.S. government have been affected.
It’s worth noting the significance of this apparent shift in the Fed’s stance, even if it contradicts recent economic indicators. Only time will tell if this pivot represents a more long-term change in policy or merely a temporary deviation from the expected path.
The Fed’s Message: No More Rate Hikes
The Federal Reserve officials have made it abundantly clear that they are hitting the brakes on raising interest rates. Fed Vice Chair Philip Jefferson and Dallas Fed President Lorie Logan both emphasized their awareness of the tightening financial conditions due to higher bond yields. Atlanta Fed President Raphael Bostic, on the other hand, straightforwardly expressed that he believes there is no need for further rate increases. This unified message from Fed officials leaves little room for interpretation.
The reasoning behind this stance is quite sensible. Higher bond yields are expected to slow down the economy, which in turn would curb inflation. Consequently, even without the Fed raising its target, the real, or inflation-adjusted, fed-funds rate is likely to increase as the inflation rate declines.
Tom Porcelli, chief U.S. economist at PGIM Fixed Income, highlights that Fed officials are actively signaling to the market that they are pausing for now. This clear communication from the Fed is being echoed by the market’s evolving perspective. Interest-rate futures pricing now indicates less than a one-in-three chance of another rate increase this year, a significant shift from the previously divided odds just a few weeks ago. However, it is important to note that the market does not anticipate rapid rate decreasing either, despite pricing in cuts of 0.75 percentage points for next year. This suggests a prevalent belief in a “higher-for-longer” interest rate scenario.
This approach is likely in the best interest of all parties involved. Any faster rate cuts than currently expected in 2024 would only come into play if the economic situation deteriorates significantly, negatively impacting earnings and the stock market.
Overall, it is evident that the Federal Reserve’s message is crystal clear: no more rate hikes for now.
The Fed’s Awareness of the Bond Market’s Impact
While it may not be a definitive sign, the Federal Reserve’s recognition of the bond market’s tightening effect is a step in the right direction. This awareness suggests that a soft landing might still be possible.