Halloween: The Fed cut, and yields went up

The ten-year US Treasury yield touched 4.28 per cent on Halloween, six weeks to the day after the Federal Reserve began easing with a 50-basis-point cut. That is 66 basis points higher than when the cut was announced. For bond investors it has been a fright.

Six weeks of bad surprises

The move was built one data release at a time. September's payroll report showed the economy adding far more jobs than expected and unemployment falling. Consumer prices for the same month came in slightly firmer than forecast. Retail sales held up. This week's first estimate of third-quarter GDP showed the economy still growing at an annualised rate close to three per cent, driven by strong consumer spending. Each release chipped away at the view, widely held in mid-September, that the Fed was starting a long and deep easing cycle.

Politics added to the pressure. As polls and betting markets moved towards Donald Trump through October, investors priced a greater chance of unfunded tax cuts and tariffs, both of which point to larger deficits and higher inflation. Across the Atlantic, the British government's budget on Wednesday raised planned borrowing and sent gilt yields sharply higher, a reminder to bond investors everywhere that fiscal plans can move markets quickly.

Cuts up front, yields up behind

Rate cuts usually bring down bond yields and loosen financial conditions along the curve. This time the curve steepened sharply instead, pushed by strong growth and rising inflation expectations, with worries about post-election deficits on top. Investors who bought duration hoping to profit from the cutting cycle have lost money. Short-dated yields, which track the Fed's policy rate more closely, have risen far less, so the damage is concentrated at the long end of the curve.

Taking the move apart

The rise can be split into its parts. Yields on inflation-protected Treasuries, which measure the real return investors demand, have risen by more than breakeven inflation rates, the gap between nominal and inflation-protected yields. That suggests the bulk of the move reflects stronger growth and a higher expected path for real interest rates, with rising inflation compensation playing a supporting role. Estimates of the term premium, the extra yield for holding long bonds, have also climbed back above zero.

The expected path of the Fed has shifted as well. In mid-September futures markets priced a policy rate falling to around three per cent by the end of next year. They now price a shallower descent, with fewer cuts spread over more meetings. The Fed has not changed its policy since September; the market has changed its mind about how far that policy will go.

This has happened before

Rising long yields after an initial cut are not unusual when the economy is healthy. After the Fed's insurance cuts in 1995 and 1998, ten-year yields rose within months as growth held up, and in the second episode the Fed ended up reversing course and raising rates the following year. In 2019 long yields also climbed off their lows after the Fed's third cut, once fears of recession faded. The pattern is the bond market's way of saying that the cuts were insurance rather than rescue.

The contrast is with the cycles that began in 2001 and 2007, when yields fell steadily as the economy slid into recession. On that evidence, the bond market's verdict so far is a vote of confidence in growth, though an expensive one for anyone who bought long bonds in September.

Who pays and who gains

The losers are obvious. Holders of long-dated Treasuries and bond funds have taken capital losses. Homebuyers face mortgage rates that have risen since the Fed cut. Companies that planned to refinance long-term debt this autumn face higher coupons. Emerging-market borrowers suffer as higher American yields strengthen the dollar and pull capital back to the United States.

The winners are fewer but real. Banks earn more when the gap between short-term funding costs and long-term lending rates widens. Savers can lock in higher yields for longer. Pension funds and insurers, whose liabilities stretch decades ahead, find it cheaper to match them with long bonds. The Treasury, by contrast, pays more on every new long bond it sells, which adds to a deficit already running at levels normally seen only in recessions.

The case for patience

Bond bulls argue that the move has gone too far. The Fed will keep cutting, they say, and inflation is close to target, so long yields should drift lower once the election is out of the way and the data cool. Hurricanes and a strike at Boeing will depress October's payroll figures, released on Friday, which could revive talk of a slowing economy. There is something in this: yields rarely move in straight lines, and a softer run of data would pull them down.

What the bulls cannot easily explain away is the fiscal backdrop. Whoever wins next week will inherit deficits in the trillions, and the Treasury must keep selling long-dated debt into a market that no longer has the Fed as a buyer. That structural pressure will not fade with a weak jobs report.

What comes next

The calendar is crowded. October's jobs report arrives on Friday, the election on Tuesday, and the Fed's decision on Thursday of next week. Markets expect a quarter-point cut, and the chair's comments on the strength of the economy will matter more than the decision itself. After that, the next inflation figures and the size of the Treasury's auctions will determine whether the steepening continues. The Treasury also publishes its quarterly borrowing plans next week, showing how much of the deficit it intends to finance with long-dated bonds rather than short-term bills. Any increase in auction sizes for long maturities would add directly to the supply that investors must absorb.

The Fed has cut into a strong economy, and the bond market has answered by raising long-term rates. Until growth cools, further cuts will probably steepen the curve again and leave ten-year yields where they are, or higher. A decisive election result that points to larger deficits would push the ten-year yield towards 4.5 per cent before the year is out.