Monetary policy tightening, the bond market and the business cycle

Central banks in developed economies are contending with a series of shocks that have threatened price stability and, ultimately, economic growth.

Now, these shocks, which include inflation, interest rate increases and energy market turmoil, are all showing up in fixed income markets.

With consumer inflation at 9.1%—its highest level since the 1970s and 1980s, when energy shortages resulted in similar crises of instability—the Federal Reserve is engaged in a campaign to restore price stability in such a way that risks causing a recession.

A rising overnight rate…

The Federal Reserve has already pushed the cost of short-term borrowing from zero to 1.75% and is expected to hike rates by at least another 1.5 percentage points over the next six months. At this point, it is difficult to make the case that the Fed will not push its policy rate to at least 4% next year before it decides to stop and focus on the maximum sustainable employment portion of its dual mandate.

…will push up long-term rates…

The increase in the overnight rate will pressure longer-term Treasury bonds and corporate bonds higher. For instance, the yield on two-year Treasury bonds is considered to be the present value of the path of the overnight rate two years out. Bonds for longer maturities—like 10-year bonds, which are linked to economic growth—tend to have their yields increase as the overnight rate rises.

…as the Fed unwinds its balance sheet

Another factor pushing interest rates higher will be the end of Federal Reserve purchases of Treasury bonds and mortgage-backed securities, and the gradual drawdown of its holdings. The increased supply of bonds on the market should increase bond yields.

Investors will seek safety…

There will also be factors out of the Fed’s control that will push yields lower. As uncertainty over the global economy increases, we can anticipate the demand for the safety of U.S. securities to increase. Interest rates in Europe and Japan remain closer to zero and the dollar continues to rise, all of which increases the attractiveness of dollar-denominated securities.

…as financial conditions tighten

The elephant in the room, however, is the effect of Fed tightening on financial conditions and economic growth. Financial conditions—as measured by the RSM US Financial Conditions Index—are significantly below normal levels of risk priced into financial assets. That implies a decreased level of economic growth in coming quarters.

The yield curves tell the story…

The difference between long-term (10-year) bond yields and short-term (three-month) money market rates has generally followed the progression of the business cycle. Because short-term money market rates respond quickly to federal funds rate settings, you would expect the spread between long-term rates and short-term rates to be the widest immediately after a recession. That spread would tend to narrow as short-term rates move higher during the recovery.

…of the Fed’s bind

When short-term rates are pushed higher as the economy overheats, you would expect the spread to narrow and turn negative as concerns grow over the health of the economy, driving bond yields lower.

The spread between 10-year bond yields and three-month Treasury bills is a mere 26 basis points, which gives credence to the notion that the Fed has no choice but to raise short-term rates to increase the cost of borrowing and lending, driving economic growth lower.

The takeaway

Because two-year bond yields are a function of the path of the overnight federal funds rate over the course of the next two years, and because the Fed is pushing the federal funds rate higher, two-year bond yields have moved higher. And because the bond market is now more concerned about the prospect of a recession, 10-year yields have moved lower in recent trading.

Though not a consistent precursor of recessions, the negative 10-year/two-year spread is nonetheless disconcerting.