Jerome Powell, Federal Reserve Chair, spoke Thursday at the Economic Club of New York. The yield on 10-year Treasury bonds reached a 16-year record. Powell stated that more tightening may be necessary if recent economic data continue to show strength. He also said the financial conditions had tightened "significantly" due to the increase in long-term bond rates.
Powell reaffirmed his commitment to "proceed carefully" and signaled that he would not be in a hurry to raise the rate again. Powell talked about the surprising strength of the economy in the discussion following his opening remarks. It may be that interest rates haven't remained high enough.
Powell also spoke about the new interest rate normal after a period with ultra-low rates that followed the financial crisis of 2008. Powell, when asked whether interest rates would return to normal between 4%-5%, said that he thought they may end up somewhere between the old norm and the ultra low era.
Powell on 10-Year Treasury Yield
Why has the yield on 10-year Treasury bonds risen? Powell said: "It is not about expectations of higher inflation." He also dismissed expectations for Fed policy changes in the short-term. He said that the term premiums are what is really going on. This is compensation investors want for holding bonds over a longer period of time.
Powell also attributed this rise to "a greater focus on fiscal deficits," and added that "QT" (quantitative Tightening or reducing the Fed’s balance sheet) may be a factor.
He said that the current debt levels were not a cause for concern, but rather, it was the fiscal trajectory. "We'll need to get off this path sooner or later."
Powell's speech saw the 10-year Treasury rate hit 4,99%. It remained at that level until late Thursday afternoon. S&P 500 began by bouncing around the flat line. It then moved down solidly, slipping 0.9% following Wednesday's 1.3% loss.
Powell's co-workers have stated that the Fed is being assisted by the rising yield on the 10-year Treasury, which is used as a major input in auto loans, 30-year mortgages and growth stock valuations. Powell acknowledged that a higher 10-year Treasury yield may "at the margins" reduce the need for rate increases.
Markets have a 0% chance of a rate hike of.25 percent on Nov. 1. However, the odds increase to 29% when it comes to the policy update of Dec. 13, and 39% in January 31.
Ten-Year Treasury Yield Risks
Recent worries about a Treasuries oversupply have increased. This risk is increased if the war between Israel and Hamas escalates. In the coming days, President Joe Biden will ask Congress to provide $100 billion for emergency funds to support Israel and Ukraine, Taiwan, and to strengthen U.S. Border Security.
The ongoing spectacle of House Republicans not being able to agree on a new speaker has also implications for Treasury. Kevin McCarthy was demoted when eight Republicans backed out of his agreement to keep the government running. But the GOP lacks the votes necessary to demand severe budget cuts.
Federal Reserve Balance Sheet
The strong economic data also highlights another risk: that the Federal Reserve may continue to unload the bonds it purchased early in the pandemic, in order to increase financial market liquidity. The Fed lets up to $95 Billion in Treasury Bonds and Mortgage Securities run off its balance each month.
The latest rise in the 10-year Treasury yield began last week, when consumer prices matched expectations of a 0.3% increase per month, but unexpectedly high service prices were reported. On Tuesday of this week, the retail sales report for September showed an increase of 0.7%, more than doubling forecasts, even though prior data had been revised upwards. The number of new claims for unemployment benefits during the week ending October 14 dropped by 13,000, to 198,000. This is the lowest level since mid-January.
The Fed will not say much until the economy has clearly slowed down. One dovish Fed member, Philadelphia Fed president Patrick Harker told The Wall Street Journal that he was ready to begin the conversation.
U.S. Treasury Loans
The Fed's supply has increased the borrowing requirements of the United States. The U.S. Treasury shocked Wall Street on July 31 by announcing that it planned to issue $1 trillion of debt via the public markets during the third quarter. The estimate of borrowing was $274 billion more than what was announced in May.
The foreign demand for U.S. Treasuries also reveals some gaps. The update on Wednesday of cross-border flows will "add to the fears" that China will not be present in funding U.S. deficits. This is according to Alan Ruskin, macro strategist at Deutsche Bank. He pointed out that China had sold $15 billion of U.S. Treasury bonds and notes, and unlike previous months, did not offset these sales by purchasing other U.S. Government agency securities.
Treasury Break Even Inflation Rate
The 10-year Treasury yield is a good indicator that the markets are more concerned about the supply of goods than they are with the inflation outlook. Before August 1, the 10-year Treasury had only briefly risen above 4%. Since then, however, the 10-year Treasury has soared by 99 basis points while the inflation outlook barely changed.
The 10-year TIPS rate (or Treasury inflation-protected securities) is subtracted from the 10-year Treasury Yield. The 10-year breakeven inflation rate rose modestly from 2.39% to 2.49% on July 25, the day before Powell announced that Fed staff did not expect a recession.
The 10-year TIPS, which takes into account inflation expectations, has increased from 1.53% to 2.50%.
Coming Interest Rate Shock?
The question is, how quickly and how hard will higher interest rates on long-term loans affect the economy? Mortgage applications to purchase a home are already at their lowest level since 1995, according to the Mortgage Bankers Association. The average 30-year mortgage is now 7.7%.
Mortgage payments have risen by $75 billion annually in October compared to the same period last year.