The Federal Reserve announced its third consecutive interest rate increase of 75 basis points (bps) on September 22, bringing the Fed funds target range to 3.00%–3.25%. Policymakers’ median estimate of the terminal Fed funds rate also increased sharply from 3.8% to 4.6%. Taken together, these two changes highlight the Fed’s concerns about inflation and their resolve in taming it.
Both the rate decision and the Fed’s upwardly revised projected path for policy rates were widely expected. Investors have priced in a more restrictive path for policy rates in recent weeks following Fed Chair Jerome Powell’s hawkish comments at the Jackson Hole Economic Policy Symposium in late August and last week’s higher-than-expected core US inflation print.
The recent rise in interest rate expectations sparked another leg up in bond yields. As of September 21’s close, two- and ten-year US Treasury yields had increased 51 bps and 41 bps, respectively, so far this month, to 3.96% and 3.56%, and they are now roughly 320 bps and 200 bps above where they started the year. Looking ahead, we expect bond markets will remain highly sensitive to inflation and other economic data releases in the near term, but the risk to yields will likely remain tilted to the upside if inflation continues to be stickier than expected.
Both policymakers and investors have underestimated inflationary pressures this cycle, resulting in both repeatedly increasing their interest rate expectations. Yet, both still expect inflation to normalize next year, which investors believe will allow the Fed to “pivot” to cutting rates by the end of 2023. This may be optimistic, given “sticky” components of inflation, such as shelter, have seen their price levels rise quickly in recent months. Therefore, interest rate expectations may still be too low, especially considering the Fed has raised the Fed funds rate above inflation in every rate hiking cycle since 1960.
More tightening increases the upside risk for Treasury yields. In prior cycles, yields have tended to keep rising as the Fed tightened policy, with the ten-year nominal yield typically reaching near or above the peak Fed funds rate. Still, tight monetary policy also increases the risk of an economic slowdown. Therefore, while we believe it is too early to go long duration because of the potential upside risk to yields in the near term, we also wouldn’t be short duration as it can provide a portfolio support in a slowdown.