The Great Rate Divide

"The world has changed. Information moves instantly, and so do decisions" – Ginn Rometty (former CEO of IBM)

For much of the post-World War II era, whenever the Federal Reserve began to cut its policy rate, long-term interest rates quickly followed suit and also saw declines in yields, leading to strong returns across fixed income markets, especially in longer-duration bonds. With the Federal Reserve expected to start cutting rates next month, a question arises: will longer-term interest rates behave similarly this time? To explore this, it’s useful to understand the historical relationship of interest rates and the yield curve as well as the current state of both.

This week’s chart plots Fed Funds target rates and U.S. 10-year Treasury yields since the early 80s. When looking at this chart several notable trends emerge. First, Fed cuts have typically coincided with periods when the U.S. was heading into or already in a recession. During these times, demand from investors seeking the safety of long-term government bonds helped push bond yields lower across the rate curve. Secondly, the yield curve has typically been either slightly inverted or flat when the Fed began cutting interest rates, with short- and long-term interest rates more or less aligned. This time around there is a very visible divergence between the level of the Fed’s policy rate and the 10-year U.S. Treasury yield. This alignment of the Fed Funds rate and 10-year yields in previous rate cutting cycles allowed more room for long term rates to fall as the curve steepened (or normalized to being positively sloped).

Given this backdrop, what does the current environment suggest as the Fed prepares to embark on a rate-cutting cycle? The context seems to be different this time. While U.S. economic data suggests softening growth, the probability of a recession according to Bloomberg economists stands at only 30%. After navigating a period where inflation surged above 9% post-pandemic, many investors anticipate the Fed’s upcoming cuts might be more of an adjustment to the realities of a more normalized inflation backdrop with the headline CPI inflation rate now officially below 3% than a panic about the state of the US economy

If the U.S. is able to avoid a recession as the Fed cuts interest rates then might not see the same rally in long term rates as in past cycles?

While longer-term treasury bonds have historically been a safe bet for investors anticipating post-rate-cut rallies, today’s economic (and inflationary) context paints a more complex picture. The significant yield curve inversion and relatively low odds of a recession complicate the outlook for long term yields unless the U.S. economy deteriorates more than currently expected.