Key Questions: Has the Bond Market Changed the Rules?

As the July 28–29 FOMC meeting approaches, investors are focused on a familiar question: Will the Federal Reserve hold interest rates steady or signal another policy move later this year? Chairman Kevin Warsh’s testimony before Congress this week suggests investors may be asking the wrong question. The better question may be this: Has the bond market changed the rules?

In his first Semiannual Monetary Policy Report to Congress as Chair, Warsh emphasized the Federal Reserve’s “resolute commitment to restore price stability.”  During questioning, he described price stability in practical terms as an environment where households and businesses don’t have to think about price changes.

Recent economic data suggests progress toward that objective.  June’s Consumer Price Index (“CPI”) and Producer Price Index (“PPI”) reports were both softer than expected, easing concerns that inflation was reaccelerating and reducing expectations for near-term policy tightening.  Under the market playbook that defined much of the past two decades, that combination would typically have produced lower Treasury yields across the curve.  Yet that didn’t happen.

Inflation Is Improving – But the Bond Market Is Looking Elsewhere

Inflation appears to be moving in the right direction.  Goods inflation has moderated significantly, supply chains have normalized, and recent data suggest the Federal Reserve continues to make steady progress toward its inflation objective.  Ordinarily, that would be expected to support lower long-term Treasury yields.  Instead, the 10-year U.S. Treasury yield has remained elevated.  That apparent contradiction may be telling investors something important.

So Why Is the U.S. 10-Year Treasury Still Elevated?

The answer may be that the bond market is increasingly looking beyond inflation.

While the Federal Reserve continues to exert considerable influence over short-term interest rates, longer-term U.S. Treasury yields increasingly reflect structural forces extending well beyond the federal funds rate.  Persistent fiscal deficits, elevated Treasury issuance, stronger real economic growth, geopolitical uncertainty, and a higher term premium have all become increasingly important drivers of longer-term borrowing costs.  In other words, investors are demanding greater compensation for lending money over a longer time horizon as inflation moderates.

Winning the fight against inflation does not necessarily guarantee lower long-term interest rates.

A Different Relationship

For years, investors viewed the Federal Reserve as the primary driver of interest rates across the entire U.S. Treasury yields and stronger returns across longer-duration fixed income investments.  Today’s market appears more nuanced.

The Federal Reserve continues to influence the front end of the yield curve.  Long-term yields, however, increasingly reflect investors' assessments of fiscal policy, Treasury supply, economic growth, a seemingly unending wave of geopolitical flare-ups (something we’ve described elsewhere as increased nationalism), and the compensation required to hold duration in a more uncertain environment.  Simply put, the Federal Reserve sets the overnight rate and the bond market price duration.

That simple distinction helps explain why moderating inflation has not produced the broad decline in long-term U.S. Treasury yields many investors expected.

What Chairman Warsh May Already Understand

Warsh has also emphasized a more disciplined, data-dependent approach to policymaking, encouraging investors to focus less on interpreting every public comment from Federal Reserve officials and more on the underlying economic fundamentals.  That philosophy appears particularly well suited for today’s market.

If longer-term interest rates are increasingly determined by structural market forces rather than solely by Federal Reserve policy, credibility may become more valuable than predictability.  Rather than attempting to steer every market expectation, the Federal Reserve may be better served by maintaining a disciplined commitment to price stability while allowing markets to determine the appropriate level of longer-term interest rates.

What This Means for Investors

For investors, this may represent an important shift.

During much of the post-financial-crisis period, anticipating the Federal Reserve’s next policy move was often enough to establish a broad duration strategy.  Today’s environment appears different.

Understanding fiscal policy, U.S. Treasury supply, term premium, and broader structural economic forces may become just as important as forecasting the next change in the federal funds rate.  That does not diminish the importance of monetary policy.  Rather, it suggests successful fixed income investing may increasingly depend on understanding how monetary policy interacts with fiscal policy, market fundamentals, and investor demand for duration. In addition, it may also have broader implications for the role fixed income can and will play within a fully diversified portfolio.

A New Playbook?

The July FOMC meeting will undoubtedly receive significant attention.  Whether policymakers ultimately hold rates steady or adjust policy later this year remains important.

The larger story, however, may be that investors are entering a market environment in which inflation, Federal Reserve policy, and long-term interest rates no longer move together as predictably as they once did.  If the bond market has indeed changed the rules, investors may need to change more than their expectations — they may need to change their framework.

Winning the fight against inflation remains essential.  Yet today’s market suggests that inflation alone may no longer determine the direction of long-term interest rates.  Understanding the broader structural forces shaping the bond market may prove just as important in the years ahead.

For more information, please contact your advisor.