At a Glance
- The Fed finds itself in an unusual position when it comes to managing inflation.
The stock market selloff that began in October looked like it may have been over once the market heard from Jerome Powell. On November 28, the Fed Chair revealed enough to indicate to the market that the Fed was going to pause in its interest rate hike cycle.
The irony of the reversal move higher in stocks is that the October selloff began in earnest as long-term rates had broken out to new annual highs and the Fed does not directly control long-term rates. Powell’s comments causing that particular rally wasn’t really germane, but it happened anyway.
The 2018 high close in yield for the U.S. 30-year bond had been 3.25 percent, reaching that level in mid- On October 3, the 30-year yield was at 3.3percent and two days later it was at 3.4percent. The U.S. 10-year note yield moved in a similar pattern in that it broke above 3 percent for the first time in the previous seven years on April 24, closing at 3.11 percent by May 17. We didn’t see a new 2018 closing high yield in the 10-year until October 3 when it hit 3.15 percent, again coinciding with the recent stock market selloff.
Long-Term Yields and Stocks
Stocks fall when long-term yields rise because U.S. notes and bonds provide the safest returns of all assets. They are known globally for the “risk-free rate of return” that they provide. When the rate of return on these assets rises to reasonable return levels, they begin to compete with stocks for investment dollars since there is no risk of loss of capital if held to maturity and that is not the case with stocks, therefore stocks fall. This brings us to now which warrants a look at the current relationship between long-term yields and stocks.
Long-Term Yields Are Not Driven by The Fed
Many analysts spent 2018 predicting higher long-term yields, based on two things: the U.S. economy was showing some wage growth which could spur inflation and the Fed was on a path to higher short-term rates. Many people listening to those analysts made the mistake of thinking because these things sound related, that the Fed raising rates causes long-term rates to go higher.
The reality is this: long-term rates move with inflation expectations. If the purchasing power of a dollar will be reduced in the future (which is what inflation does) then people will want to earn a higher yield on long-term debt in order to have more of those weaker dollars in the future to spend. This causes long-term rates to rise.
The Fed, on the other hand, raises short-term rates in order to try and slow the economy before it overheats and stop inflation before it gets out of hand. This means that, in theory, if the Fed were ever completely successful, then long-term rates wouldn’t move much because the Fed would have inflation under control.
A Unique Inflation Scenario
Herein lies the “this time is different” problem the Fed now faces. By the traditional measures of inflation the Fed is known to study, which are the consumer price index (CPI) and the personal consumption expenditures (PCE) deflator, there just isn’t much inflation present. Yet in October, long-term rates rose and stocks fell because of it.
This gave the Fed cover the raise short-term rates to head off the inflation that long-term rates seemed to be concerned with. Then something happened. Long-term rates began to fall. The markets ended up looking at a Fed that was hiking rates and a long end of the yield curve showing no inflation fear and falling.
Wages are still growing which is what has historically and reliably preceded inflation, but what if automation and online related discounting have taken the traditional measures of inflation so far off the data screens that the Fed has no idea whether it’s looking at potential inflation drivers or not?
You could end up with a Fed in a tightening cycle and an economy with no price pressures. That leads to an inverted yield curve and potentially a recession. Don’t look now…