Can interest rates fall and US Treasury yields increase at the same time?
Yes, the inverse relationship between interest rates and yields is not always perfect.
It is possible for interest rates and US Treasury yields to move in opposite directions.
Short-term interest rates, like the Federal Funds rate set by the Federal Reserve, can fall while longer-term Treasury yields rise.
This typically occurs when the market expects higher inflation in the future. When the Fed lowers short-term rates, it makes borrowing cheaper and boosts economic growth expectations.
However, if investors anticipate higher future inflation due to this growth, they will demand higher yields on longer-term bonds to compensate for the expected erosion of purchasing power. This drives Treasury yields higher even as the Federal Reserve cuts policy rates.
Additionally, factors like increased government borrowing (which tends to increase the supply of bonds) or reduced demand for safe-haven Treasuries can push yields higher, even if the Fed is lowering short-term rates to stimulate the economy.
In late 1995, US Treasury yields rose on concerns over the US debt ceiling and budget impasse. There was a temporary government shutdown in December 1995 as Congress and the President could not agree on a budget, raising fears of a potential default on US debt obligations. Investors sold Treasury bonds as they demanded higher risk premiums.
Additionally, there were shifts in monetary policy expectations and anticipation of stronger economic growth. As the 1996 presidential campaign began, markets anticipated higher growth and inflation, leading to expectations of tighter monetary policy from the Federal Reserve. This caused Treasury yields to rise, with the 30-year bond yield increasing by nearly 50 basis points in February 1996.
Other episodes in history also showed that interest rates can stay low while US Treasury yields continue rising. For instance, the announcement of the Fed tapering in 2013 (i.e. withdrawing purchases from its monetary stimulus program) and the use of taxpayer’s money to bail out large US banks dented investor expectations and caused a sell-off in Treasury bonds.
Will the Fed cut interest rates within the next two months?
According to probabilities calculated by 30-Day Fed Funds futures, the US Federal Reserve is likely to keep interest rates on hold at the 11 June meeting. As seen in this chart, there is a 98% probability that the target range will be maintained at 5.25% - 5.50%.
Based on another chart, participants also expect interest rates to be on hold in July.
But most investors do not know what will happen at the FOMC September 2024 meeting as the probabilities have diverged, albeit the distribution range suggest that majority expect rates to be lower rather than higher.
Source: CME FedWatch Tool, as of 7 June 2024
This is why interest rates may not have peaked
Despite what the Fed funds futures market is pricing, some think tanks believe that rates have not peaked. According to research at ING Bank, the 10-year yield has not behaved, or fallen in a manner that is typically expected from a “Fed peak moment”.
In prior rate cut cycles, the 10-year US Treasury yield usually precedes the Fed’s decision. Yields tend to fall first when rates plateau, before the Fed lowers interest rates. During the 2000 peak, the 10-year was trading at a yield of ~6-7% before falling to ~4-5% before the first rate cut in January 2001.
If the ING study is right, recent spikes in the Treasury market suggest that rates could stay elevated in the meantime. The market reaction to the jobs data last Friday was rather quick. Wages are holding up, and a Bloomberg article said that the May jobs data tempered interest rate cut expectations as nonfarm payrolls were more resilient than projected.
We could see a tug of war between bulls and bears in June and July, which would set the tone for the rest of the year
It is still a matter of debate where interest rates will eventually land. Investors will pay close attention to upcoming economic data before deciding on breaking out to the upside or downside.
From a valuation perspective, long term bond yields are attractive but catching the bottom of this market would not be easy. Fortune favors the brave and chances are, you might get cuts along the way before you eventually discover the bottom.
The less stressful and more obvious choice is to continue investing and rolling over short term bonds as the short end of the curve is still providing a yield that is higher than the long end.
For instance, 3-month US Treasury bills are yielding 5.376% (7 June 2024), while the 30-year bond has a yield of 4.558%. In the Singapore context, the 6-month T-bill rate is at ~3.76%, which is higher than the 30-year yield of ~3.11%.
Disclaimer
Seven Fat Cows is not a financial adviser. You should seek independent legal, financial, or other advice to check if the information from this website relates to your unique circumstances.