The fallout of the Federal Reserve’s major interest rate cut last week hasn’t gone exactly to plan, as perhaps the most crucial borrowing metric has gone higher and the market now expects the Fed to roll out another supersized cut at its next meeting in six weeks.
Home mortgage rates are posted outside a real estate office in Los Angeles last week.
Since the Fed announced last Wednesday it would lower the target federal funds rate by 50 basis points from 5.25%-5.5% to 4.75%-5%, yields for 10-year Treasury notes have increased from about 3.6% to almost 3.8%, registering the highest level in three weeks.
The increase in the 10-year government bond yields is key for borrowers, as the 10-year rate is the benchmark for loans like mortgages and auto rates, meaning some loans are actually more, not less, expensive this week than they were before the Fed slashed rates, defying conventional wisdom.
At the same time, expectations have shifted for the Fed at its next meeting, Nov. 6-7, to enact another 50 basis-point cut as some evidence piles up that the economy needs even more of a jolt from monetary policy.
The market-implied odds of a 50 basis-point cut in November have climbed over the last week from 37% to 60%, according to CME Group data tracking derivatives trades on the federal funds rate’s direction, compared to a week-over-week drop for the implied probability of a 25 basis-point cut from 62% to 41%.
Treasury yields and odds of a bigger Fed cut are simultaneously climbing even though they should logically move against each other, as higher bond yields indicate a belief that borrowing costs will remain higher, and a belief in big Fed rate cuts point to a likely decline in borrowing costs.
That’s because consensus is split in the market on if inflation, which caused hikes in the first place, will prove more stubborn than hoped, as lingering inflation would lead to higher interest rates in the longer run, while light inflation would empower the Fed to substantially lower rates.
Longer-dated bonds are a proxy for where fixed income traders expect the federal funds rate to go in the longer run, and are thus less immediately sensitive to Fed actions. On the flip side, short-dated Treasury notes have declined rapidly after the Fed cut, with 6-month, 1-year and 2-year yields all checking in at about 2-year lows Wednesday. Experts suggest the perhaps perplexing move in the benchmark 10-year Treasury note is a result of investors already pricing in the Fed pivot to lower rates; the 10-year is down big from the nearly 4.5% level it sat at the beginning of July, already driving down mortgage rates.
Yields for the 10-year Treasury move as bond traders assess the U.S.’ risk and monetary policy environment, and lower yields indicate more valuable bonds, as investors demand a lower coupon rate to buy government debt. It’s common for assets to initially lose value after a highly anticipated event which should help its price long term. The stock market has reacted overwhelmingly positively to the Fed cut, with the S&P 500 up more than 2% since the announcement to an all-time high, as stocks rally due to expectations companies will soon get cheaper loans, helping profit margins. In a Wednesday note to clients, Sevens Report analyst Tom Essaye wrote that bumpiness in the 10-year “will not be a headwind on stocks” so long as it “tread[s]
In another sign of a potential lack of investor confidence in the Fed’s actions, gold prices have steadily climbed over the last week to a new record high, trading at almost $2,670 per troy ounce Wednesday, up almost 4% since the date of the Fed cut.