By Kyle Tetting
July brought another closely watched meeting at the Federal Reserve with another chance for Fed Chair Kevin Warsh and the Federal Open Market Committee to make changes in response to either inflationary pressures or concerns about economic growth. Often lost in the nuance of these meetings, however, is that the current economic environment isn’t terribly receptive to the tools the Fed has in its toolbox, especially near term.
Higher rates — as advocated for by regional bank presidents in Minneapolis, Dallas and Cleveland — would in theory place some downward pressure on inflation. In practice, some of the largest contributors to year-over-year inflation in recent months have come from energy prices. In June, U.S. energy prices had increased 15.7% over the prior 12-month period. Interest rate changes, even meaningful rate changes, don’t move the needle much in such a volatile category when compared to the impact of war and the resulting supply constraints.
In other words, and this doesn’t let the Fed off the hook entirely, it’s been clear for some time that inflationary ebbs and flows have been in spite of the Federal Reserve, not because of it. Supply/demand imbalance, first the result of a pandemic and now a war, remains the more obvious culprit.
Lower rates — supported by some outside the Fed — might work to further stimulate economic growth, but we don’t currently have a growth problem or an unemployment problem. The downside to increased economic growth stimulated by rate cuts would be increased demand with the potential to further exacerbate inflation.
Now that it’s recognized the toolbox may not have a better solution, we now have a Fed that’s largely decided we live in an environment where economic growth has been “not too cold” and inflation has been “not too hot,” and it can continue to stay out of the way of an economy that continues to thread the needle.
But, importantly, the Federal Reserve controls just one part of the yield curve: the overnight lending rate — an important rate for banks’ overnight borrowing and lending, and a driver of many consumer loans and savings rates, but less influential when looking to longer-term maturity instruments.
Mortgage rates and corporate borrowing, for example, are much longer term than “overnight.” Further, our government’s growing debt is considerably longer dated, with an average maturity of around five years and just around a third of government debt maturing in a year or less. It’s in these longer-dated bonds that we’re seeing a more obvious change.
The 30-year Treasury yield recently hit its highest level in 30 years, closing the month of July at 5.28%. Since rates on longer-dated treasurys are controlled entirely by investor appetite, the broader investor base is doing the work the Fed can’t or won’t do. These higher rates ultimately work to suppress demand as they make their way into comparable rates on mortgages and corporate borrowing and, in turn, may help to slow inflation more quickly and more directly than the Fed’s traditional tools.
Given the source of the problem and a market that appears to be self-correcting, it appears the right choice for the Fed to sit back for now to allow geopolitics and market forces to work as they are intended.
Balanced investors experienced some pressure within their bond funds as rates rose, but situations like the 2022 decline in bonds have largely been avoided this time, thanks to a more measured rate move and the higher interest rate environment leading into this year. More importantly, the mostly flat returns of bonds have been more than overshadowed by a stock market that is, once again, off to the races.
The challenge now is to avoid extrapolating the return of stocks or bonds in the immediate future. Stocks may continue on this path and bonds may continue to face headwinds, but the roles they play remain vastly different for our portfolios, and the opportunity set for fixed income amidst now higher rates is tough to ignore.
Kyle Tetting is the president of Landaas & Company