The seemingly relentless rise in yields across the curve continues to weigh on market performance. The news of the week centered around a hawkish pause by the Federal Reserve – the Fed Funds rate was held at the current level (5.25%-5.50%) but the rhetoric suggests a strong desire for another hike before year end. While the path for future rates should remain data dependent, the toll of the fastest rate hike cycle in history is pressuring markets. The 10-year Treasury yield has increased more than 30 basis points in September and briefly touched 4.5% before retreating modestly to 4.4%, the highest weekly close since 2007. On the equity side, segments sensitive to long-term rates, namely unprofitable technology and small caps, led the way lower as high valuations become difficult to justify amid higher bond yields. The S&P 500 ended the week down -2.9% and the US Aggregate bond index traded lower by -0.5%.
Prior to the Federal Reserve meeting, markets had been expecting almost two full rate cuts over the next 12 months. Following the release of the Fed “dots” showing 12 out of 19 Fed officials expect another rate hike in 2023 and FOMC members generally expect fewer cuts going forward, the market priced in less than one rate cut over the next 12 months. The pause was expected but the hawkish tilt for future rates was not. The Fed has clearly reiterated its stance to bring inflation back to their 2% target which should keep upward pressure on short-term rates. Fed Chair Jerome Powell said at the press conference, “we are committed to achieving and sustaining a stance of monetary policy that is sufficiently restrictive to bring inflation down to our 2% goal over time.” He emphasized the Fed will “proceed carefully” as it assesses incoming data and the evolving outlook—echoing remarks he made last month in Wyoming. Investors moved quickly to protect from further bond selloffs (pushing long-term yields higher) amid surging oil prices, a massive fiscal deficit, and a looming budget standoff, alongside the resilience of the US economy.
The combination of sticky inflation, resilient labor data, and robust economic growth has powered yields higher on the long end of the curve. With rates on the short end holding relatively steady, the inversion that has been persistent since 2021 has been reverting. A steepening of the yield curve would be a welcome form of monetary tightening and evidence of a healthy economy. As low interest rate debt matures and borrowers need to re-finance their capital structure, higher interest costs are likely to be a drag on company fundamentals.
Perhaps it was not all bad news. Fed projections showed they expect inflation to fall below 3% in 2024 and to the 2% target by 2026. Additionally, the Fed now sees more robust growth and better employment trends for the next several years. Fed forecasts suggest the probability of a soft landing is now the base case – a view that is too optimistic for many analysts and economists.
For fixed income investors, this has been a particularly painful period dating back to early 2021 when markets were sniffing out a rate hiking regime. Since year-end 2020, the US Aggregate bond index is down -14.5% and US government debt as measured by the Bloomberg US Treasury index is down -15.5%. Investors looked to 2023 to be a year when fixed income bounced back with rates normalizing and yields supportive of total return. Instead, the insistent yield pressure has pushed fixed income returns into negative territory year-to-date.
Source: Bloomberg, Federal Reserve