submitted by
Uric Dufrene, Ph.D., Sanders Chair in Business, Indiana University Southeast
Ever since the Fed unexpectedly reduced rates by 50 basis points, the bond market for the 10-year Treasury moved in a different direction. Just prior to the September Federal Reserve meeting that produced the oversized and unnecessary reduction of ½%, the rate on the 10-year yield had hit a recent low of 3.66%. The Fed announcement came on September 18th, and two days after, rates on the 10- year yield had climbed to 3.73%. Since then, rates have moved in an upward direction, with the most recent at 4.08%.
If we dissect the components of the 10-year Treasury, it is impacted by two primary drivers. One is anticipated growth in the economy, and the other is expected inflation. If the market perceives that growth is going to slow down, then we would expect the 10-Year yield to decline. As investors perceive slower growth, they might find bonds to be more attractive than equities, increasing demand for Treasuries, and thereby increasing the price. Bond prices and interest rates are inversely related. So, an increase in demand for bonds will push interest rates down. So, when investors anticipate slower growth, we can expect the 10-year yield to decline. On the contrary, higher anticipated growth will push bond yields higher, as investors move to equities and push bond prices lower and yields higher. An example of higher growth came in the last retail sales report that showed better than anticipated retail sales, and as a result, GDP estimates were revised upward.
The other component to the 10-year yield is anticipated inflation, and bondholders expect to be compensated for inflation. Otherwise, bonds lose out to inflation and the result is reduced purchasing power in subsequent years. Since the Fed announced the reduction in rates, expected inflation, as measured by the difference between 5-year Treasury Inflation Protected Securities (TIPS) and 5-year bonds, increased from 1.98% to 2.23%. Since the oversized reduction by the Fed, the inflation narrative is beginning to resurrect from just a few weeks ago. Expected inflation has moved up, and actual inflation, as measured by the last Consumer Price Index (CPI), came in higher than expected. As we cited a few weeks ago in Economic Update, the Fed may be approaching a pause on rate reductions, or certainly rate reductions that will be less aggressive. The Fed Watch Tool is showing probabilities that favor four consecutive reductions of 25 basis points each. As we go through the next several months, we’ll likely see the odds revised and the number of cuts reduced.
The implications of higher 10-year Treasury yields will be felt across several fronts. One is higher mortgage rates. Since the last Fed rate reduction, mortgage rates have moved from 6.14% to 6.52%. Rates on auto loans and credit cards will also move higher, compounding some of the complications faced in the auto sector and consumer financing.
Even with higher mortgage rates, homeowners have been tapping into home equity, helping fuel consumer spending. Home values have increased significantly since the pandemic, increasing the net worth of existing homeowners. Higher home values have increased homeowner’s equity, and homeowners are taking advantage of this increased equity through a resurgence in home equity loans. From 2008 to 2021, home equity loans saw consistent declines in volume. Since 2021 however, home equity financing has been on the upswing. Tapping into home equity lines of credit will support additional growth overall.
To sum up, the 10-year is increasing once again, reflecting a combination of higher growth and inflation. The combination of both will force the Fed to step on the brakes again, and the result will be fewer rate reductions.
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