The focus of the market is on how long the Federal Reserve under Powell will maintain high interest rates.
James Mackintosh
November 6, 2023
Last Wednesday's US market perfectly demonstrated the three most important issues it faces: economic conditions, government spending, and the Federal Reserve.
The yield of 10-year US treasury bond bonds recorded the third largest one-day decline since the collapse of Silicon Valley Bank in March. Investors attach equal importance to these three issues. The easing of each issue has reduced the yield of treasury bond by 0.05 percentage points. Investors' concerns about economic growth, the size of treasury bond issuance, and how long the Federal Reserve will maintain high interest rates have eased.
These three major issues are all very important. But in the long run, the US economy is the most important, not only directly affecting bond yields, but also indirectly influencing bond yields by helping to determine the size of government borrowing and the actions of the Federal Reserve. If you can grasp the pulse of the US economy, your investment portfolio will thrive. Here are two very important considerations that I will discuss later.
The first major news on last Wednesday was that the issuance of long-term treasury bond announced by the US Treasury Department was 2 billion less than expected and would stop expanding the issuance scale after March next year, earlier than expected. The prospect of bond supply falling below market expectations will lower the term premium, thereby driving down yields. Term premium refers to the additional yield required by investors to hold bonds that is higher than the future interest rate path.
The rapid increase in bond yields since the summer is largely due to the rise in term premium, although different estimation methods differ on the specific magnitude of the premium. The other reason for the increase in yields is that the market has come to believe that the Federal Reserve plans to maintain higher interest rates for a longer period of time.
In the short term, term premium is crucial for investors. According to a measurement index of the Federal Reserve Bank of New York, the 10-year term premium has risen by more than one percentage point since July, which explains all the increases in treasury bond bond yields, while the increase in treasury bond bond yields itself helps explain the 10% pullback in the stock market. Other estimation methods for term premium show a smaller increase (I suspect it is closer to the truth), but it is indeed very important.
In the long run, changes in term premiums are far less important than changes in interest rates. For example, the Federal Reserve Bank of New York estimated that from 2003 to 2006, the term premium fell by nearly 3 percentage points, offsetting the impact of rising interest rates, thus helping to curb the rise of residential mortgage interest rates during the real estate foam.
However, the expectation of future interest rate trend is almost always the main driver of treasury bond yield in the next 10 years. As Gerard Minack of Minack Advisors pointed out, in the real long run, the significant decline in US debt from 1945 to the 1970s coincided with an increase in bond yields, while the significant increase in debt from 1980 to 2020 coincided with a decrease in bond yields.
The second economic event on Wednesday was a disappointing manufacturing survey released by the Institute for Supply Management (ISM), which helped lower future interest rate expectations, indicating that the economy was weaker than expected. Economic weakness means less pressure from the Federal Reserve to raise interest rates and lower bond yields.
The ISM manufacturing survey used to be an important guide for predicting future economic trends, especially its inventory and new order data. Recently, due to the ups and downs in the supply and demand relationship, this situation has become complicated and the relationship between the two has become even weaker. However, like the job market, it remains one of the important indicators for measuring the potential health of the economy.
The third major event last Wednesday was the Federal Reserve's announcement of interest rate decisions. The results are basically the same as expected, and investors may have different opinions on this. Federal Reserve Chairman Jerome Powell insists that the Fed has not considered lowering interest rates, saying, "The question we need to ask is, should we further raise interest rates
After experiencing the strongest quarterly GDP growth since the Federal Reserve began raising interest rates, this comment is easily seen as a sign of a bias towards tightening policies. However, investors are happy to interpret Powell's attention to the degree of inflation decline and his reticence about economic strength as signals that interest rates have peaked. US treasury bond bond yields fell again.
Of course, the Federal Reserve has a lot of power. As long as it is willing, it can ignore everything that happens in the economy and push up the yield by buying and selling US treasury bond bonds and setting the federal funds interest rate. But investors believe that they have a rough understanding of how the Federal Reserve will respond to economic data, so what really matters is the data itself.
Predict the economy, then you can predict what is truly important. Of course, predicting the economy is exceptionally difficult, as evidenced by the poor record of professional economists. However, there are some precautions here.
Firstly, government debt may be more important than in the past. There is no indication that Democrats or Republicans are concerned about the deficit issue, and both US President Joe Biden and his predecessor, Donald J. Trump, have chosen to borrow heavily, even during periods of very good economic performance.
The United States is still far from a debt disaster, but last year's crisis in the UK showed this danger, when investors panicked about the sustainability of an unfunded tax reduction plan and sold off government bonds.
Secondly, the Federal Reserve may not always focus on inflation. The Federal Reserve's mission is to achieve full employment and low inflation, which is also an explanation for keeping interest rates too low even when inflation starts to rebound in 2021.
The Federal Reserve has always been fortunate not to have to make a choice between the two, as the Fed's interest rate hike did not lead to unemployment issues. If higher interest rates ultimately start to have an impact on the economy, it will be harder for Powell to avoid making trade-offs. Although I hope he will continue to focus on inflation, he may not.