The Big Picture

The day is September 17. The 2-yr note yield is 3.60% and the 10-yr note yield is 3.64%. The market is eagerly anticipating a rate cut by the Federal Reserve on September 18. The Federal Reserve did not disappoint.

On September 18, the Federal Open Market Committee (FOMC) voted to cut the target range for the fed funds rate by 50 basis points to 4.75-5.00%. That was not a unanimous vote. Fed Governor Bowman dissented in favor of a smaller 25-basis points cut.

What followed the rate cut news was interesting in more ways than one. Something that stood out is that rates at the front of the yield curve and the back of the curve both went up after the FOMC cut rates.

Eyes Wide Open

The 2-yr note is more sensitive to changes in the fed funds rate. It went down initially on the rate cut, but at 3.95% today, it sits 35 basis points higher than where it was on September 17.

This adjustment stems from an acceptance that the market got too far ahead of itself in pricing in rate cuts, so the market has given back some of what it took in its hopeful policy easing view.

Interestingly, the fed funds futures market is in alignment now with the Fed's own median estimate that there will be another 50 basis points of easing before the end of 2024 and another 100 basis points in 2025. Shortly before the September 18 rate cut decision, the fed funds futures market had priced in 100 basis points of easing before the end of 2024 and another 150 basis points by September 2025.

The difference is that the market now sees 50 basis points less of easing by September 2025, so it stands to reason why the 2-yr note yield has risen since that September 18 decision.

The changed outlook has been a byproduct of two things: (1) the arrival of economic data that remains suggestive of a soft landing/no landing outlook and (2) Fed officials, including Fed Chair Powell, tamping down the market's more aggressive rate cut outlook.

Fed Chair Powell set the tone in this respect, saying overtly that there is likely to be two more 25-basis points cuts before the end of 2024 if the economy evolves as expected. It's worth noting that Atlanta Fed President Bostic (FOMC voter) said recently that he would be open to skipping a rate cut in November. He said that following a Consumer Price Index for September that featured a 3.3% year-over-year increase in core-CPI, which excludes food and energy, up from 3.2% in August.

That is a long way still from the Fed's 2% inflation goal, which admittedly is targeted for the PCE inflation rate, but it goes to show that the Fed can't declare mission accomplished on its inflation mandate as it tends to shoring up the labor market with easier monetary policy.

The long end of the yield curve, which is more sensitive to inflation and which the Fed does not control, is eyes wide open in this respect.

Inflation Relapse?

The 10-yr note yield, which hit 4.11% this past week, sits currently at 4.07%, up 43 basis points from where it was on September 17.

Long rates were expected by many to come down further when the Fed started cutting rates. That's because the Fed wouldn't cut rates unless it was confident inflation would hit its 2% target on a sustained basis, right?

With PCE inflation up 2.2% year-over-year in August, the Fed has room to feel confident. 

That doesn't mean, however, the market isn't worried about an inflation relapse. After all, the labor market is still in solid shape, evidenced by a 254,000 increase in September nonfarm payrolls, a 4.1% unemployment rate, and a 4.0% increase in average hourly earnings. Furthermore:

• The S&P 500 is at a record high.
• The personal savings rate, at 4.8%, is much higher than previously thought before recent revisions.
• There is a record $6.47 trillion in money market funds.
• The services sector saw an acceleration in activity in September and an increase in prices.
• China has announced a new wave of policy stimulus that has pushed up commodity prices.
• Gold, considered a hedge against inflation, recently hit a record high.
• Major central banks around the world are cutting rates.
• Oil futures have pressed higher on the escalating military tension between Israel and Iran.

An Uncomfortable Thought

Is this inflation worry why the 10-yr note yield has risen after the Fed cut rates? It's possible, but it is also possible that the back of the curve, like the front of the curve, has adjusted simply to account for a better-than-feared economic outlook, which would mean fewer rate cuts.

Other considerations include an asset reallocation trade out of bonds and into a stock market that keeps climbing a wall of worry, aided by its belief in the soft landing outcome, the AI revolution, the continuation of rate cuts, and the restoration of the so-called "Fed put," which is to say the market believes the Fed will be quick to step in with policy accommodation to prevent a stock market meltdown that would threaten the smooth functioning of the financial system.

Another explanation revolves around the persistent budget deficit and incessant increase in the national debt, which is $35.7 trillion or 124.3% of GDP.

The added concern is that there isn't any concerted effort in Washington to reverse this untenable situation. The CBO estimates the budget deficit will be $1.8 trillion in FY24, up 11% from FY23. Additionally, the economic plans put forward by both presidential candidates are projected to add $3.5-7.5 trillion more in new debt over 10 years, according to the Committee for a Responsible Federal Budget.

The worry is that the exploding debt will either drive interest rates up or that bond vigilantes will drive interest rates up to force the U.S. government's hand into getting the debt situation under control. Neither is a comfortable thought.

What It All Means

The stock market for its part has looked plenty comfortable following the September 18 rate cut. The market cap-weighted S&P 500, the equal-weighted S&P 500, Dow Jones Industrial Average, and S&P Midcap 400 have all hit new record highs.

They have done so with market rates rising, which suggests the stock market has welcomed the rise in rates so far as an expression of a stronger growth outlook that will be good for corporate earnings as opposed to the scarier thoughts of inflation reigniting or the debt problem coming home to roost.

That doesn't mean the stock market can't, or won't, change its mind if circumstances change.

Neither the Treasury market nor the stock market needs an inflation scare or a debt scare, but it is the Treasury market that is likely to suss things out first, so keep an eye on the back end of the curve, which the Fed does not control.

The stock market can tolerate higher rates against a better growth backdrop, but it will struggle with a rapid increase in rates driven by an inflation scare or a debt scare, particularly since the stock market trades with a full, if not rich, valuation.

Where the 10-yr note yield goes, then, and how fast it goes in the direction of travel, will have a lot to do with the stock market's next step and its view of the Fed's credibility.

--Patrick J. O'Hare, Briefing.com

(Editor's Note: the next installment of The Big Picture will be published the week of October 21)