The Bond Market is Doing the Fed’s Work

The Federal Reserve raised the federal funds rate by 0.25% in September, bringing the overnight lending rate to 4%. The decision was unanimous and reflected a familiar challenge: economic growth remains solid and consumer spending has been resilient, and inflation is still above the Fed’s 2% goal.

The increase was important, but it largely confirmed what the bond market had already been signaling for much of the year. The Fed controls the overnight lending rate, while the bond market controls longerterm rates that often matter more to households, businesses and investors.

That rise in longer term rates matters because the 10-year Treasury influences mortgage rates, corporate borrowing costs, government debt service and the valuation of risk assets. Higher yields make homes and business investments more expensive to finance. They also increase the government’s interest expense and create more competition for stocks because investors can earn attractive returns from high-quality bonds.

Several forces have pushed longer-term yields higher. Rising oil prices renewed concerns that inflation could remain elevated. Economic data remained stronger than expected, supported by solid retail sales, corporate earnings and capital investment. Investors also demanded more compensation for the growing supply of government debt and the uncertainty surrounding future budget deficits.

Global markets have also added pressure. Government bond yields rose in the United Kingdom amid political and fiscal concerns. Japanese yields moved higher as investors considered the cost of an aging population, greater defense spending and additional fiscal support. Ultimately, higher global yields make United States Treasuries relatively less attractive, unless their yields rise as well.

The good news is that long-term inflation expectations remain relatively contained. Market-derived future inflation expectations remained near 2.3%; close to the Fed’s long-term target. Investors are telegraphing some concern about current inflation, but they are not forecasting return to the high inflation following the COVID pandemic.

The September increase shows the interaction between the Fed’s monetary policy and the financial markets. If bond investors believe inflation will remain elevated, they generally demand higher yields. Those higher yields can tighten financial conditions even without a change in the fed funds rate and could thereby make it more difficult for the Fed to leave its overnight rate unchanged.

For investors, higher rates often create near-term volatility but also a better long-term opportunity. Bond yields are now among the most attractive levels we have seen in many years. Investors are being paid more to hold high-quality bonds, and those higherstarting yields improve the outlook for future bond returns. In addition, we expect bonds to act like bonds during the next inevitable volatility in the stock market. In “risk off” environments, bonds most often appreciate in value as risk assets sell off, creating an important anchor to windward for client portfolios.

Disclosure

The views expressed represent the opinion of Ferguson Wellman. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Statements of future expectations, estimates, projections and other forward-looking statements are based on available information and Ferguson Wellman’s views as of the time of these statements. Past performance may not be indicative of future results. Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational purposes only and not as a substitute for qualified counsel who can determine how this information applies to you. We believe the information provided is from reliable sources but should not be assumed accurate or complete.

Please see additional disclosures.