The Fed Hiked. Did the Bond Market Already Do the Work?

The Federal Reserve raised the federal funds rate by 25 basis points (bps), or 0.25%, on Wednesday, lifting the target range to 3.75%–4.00%. The vote was unanimous, 12-0, and the decision surprised no one, with futures markets assigning a probability of more than 90% that the Fed would raise rates. Recent economic and inflation data persuaded the Fed to lift rates. Specifically, private-sector job gains have accelerated, retail sales boomed last month and recent oil prices above $100/barrel pushed inflation numbers further above the Fed’s 2% target.

Although Fed hikes get headlines, the impact of a 0.25% shift in the federal funds rate pales in comparison to the increase we’ve seen in the 10-year Treasury rate in the last several months. Since the end of February, the 10-year Treasury rate has climbed from 4% to 5%. This week, the 10-year touched a level last seen in 2007. In terms of economic impact, the fed funds rate is relatively minimal, as it governs only overnight lending between banks; the 10-year governs almost everything else. Thirty-year mortgages are priced off of the 10-year, corporate borrowing costs are benchmarked to it and discount rates for equities, private assets and commercial real estate are built on it. Auto loans and credit card rates take their cues from the 10-year. For the broader economy a 25bp move in the funds rate is a rounding error next to a 100bp move in the 10-year.

Put differently: the bond market has likely already done the Fed's job. Financial conditions tightened meaningfully over the summer without any Fed action. Wednesday's hike ratified what the Treasury market had been saying for months.

We have argued for the past year that a 10-year yield above 4.75% is a headwind for equities making new highs, but not a catastrophe. At that level, bonds generally become a real competitor for capital, the math on equity valuations gets harder and the marginal buyer may start asking why they should pay up for growth when a risk-free note pays 5%.

While the speed of this move in interest rates has been jarring, the absolute level is not. The chart below plots the 10-year Treasury yield against nominal gross domestic product (GDP) growth (10-year moving average) back to 1955. For most of the past 70 years, the two lines have moved in lockstep. That makes intuitive sense: over long horizons, the return demanded on risk-free capital should approximate the growth rate of the economy generating it. Lenders want compensation roughly equal to the nominal expansion of the underlying economy. The exception began in 2008 with the financial crisis and quantitative easing. The recent move in rates has simply brought us back in line with the historical relationship.

Takeaways for the Week

• The Fed raised rates this week, but the bond market has been tightening financial conditions for the last several months
• The S&P 500’s last all-time high was right when the 10-year Treasury crossed the 4.75% threshold
• While rates are moving higher, underlying economic fundamentals remain very healthy and corporate earnings are booming. Rates are a headwind, but earnings are a massive tailwind

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