Treasurys are the backbone of the entire financial system, and they have been making some big moves lately. In the past few weeks, there has been a solid uptick in the 10-year Treasury yield. This increase clashes with the market’s anticipation that the Federal Reserve may become more aggressive with rate cuts soon.
Meanwhile, the spread between the 10-year and the 3-month Treasury is still at a stark -149 basis points – not too far from the lows seen in 2023. Why does this matter?
Because traditionally, before the onset of a recession, these spreads tend to turn positive, often because of rate cuts that impact the short end of the yield curve.
The market consensus suggests that we may not see 150 basis points worth of rate cuts for another 12 months, and this is considered an optimistic stance. The current situation makes it challenging to see the Federal Reserve adopting a significantly dovish policy, especially as core inflation hovers around 4% without a clear downward trend. Lowering interest rates while inflation remains elevated could potentially ignite a second wave of inflation, reminiscent of the challenges faced in 2022.
Several factors affect the 10-year Treasury yield, such as investor sentiment, economic stability, geopolitical events, interest rates, and inflation. The Federal Reserve’s short-term federal funds target rate, which it controls to influence the economy, has a direct impact on yields.
When the Fed raises rates to combat inflation, it typically leads to a rise in Treasury yields. Conversely, when the Fed signals potential rate cuts, as it did in December 2023, it can lead to a decrease in longer-term bond yields.
The Bottom Line
The bottom line? The Fed faces the challenge of maintaining modest inflation while supporting a strong labor market. Achieving this balance could enable a moderation of its interest rate policy, eventually normalizing the yield curve. However, the persistence of near-4% inflation poses a conundrum for the Fed, as it must decide whether to prioritize inflation control or economic growth support. Treasurys are running the show though, so their movement will matter for what the Fed does next.
As we move through the year, the interplay between Treasury yields, Federal Reserve policy, inflation, and investor sentiment will be pivotal themes.
Investors will closely the Treasury market’s signals and the Fed’s response to inflation. It remains to be seen whether the Federal Reserve will implement rate cuts and how this will affect the Treasury market and the broader economy.
It’s hard for the Fed to justify cuts until credit spreads really blow out, which I expect is still coming. Either way, this looks like a year that will surprise everyone, including the Fed, again.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
