Treasury Yield Volatility Means Market Thinks Fed Should’ve Done More

U.S. Treasury yields whipsawed on Wednesday before settling slightly lower. The Federal Reserve, as widely expected, cut its benchmark interest rate 25-basis point so this news had little impact on the price action. What drove the volatility was Fed Chair Jerome Powell’s comment that the central bank’s rate cut was simply a mid-cycle “adjustment.”

Powell’s comment clearly forced investors to make adjustments to their fixed income portfolios. The yields on the benchmark 10-year Treasury note, settled lower to trade at 2.013%. The 2-year Treasury yields, more sensitive to changes in Fed policy, rose 2 basis points to 1.872%.

The Details

The Fed voted at its two-day July meeting to cut its benchmark overnight lending rate by one quarter-point to a target range of 2% to 2.25%. Additionally, Fed policymakers said the central bank would stop reducing the size of its balance sheet, which consists of bonds and mortgage-backed securities it purchased following the 2008 financial crisis.

Mid-Cycle ‘Adjustment’

“We’re thinking of it essentially as a mid-cycle adjustment to policy,” Powell said during a press conference after the release.

“When you think about rate-cutting cycles, they go on for a long time and the committee’s not seeing that,” he added. “You would do that if you saw real economic weakness and you thought that the federal funds rate needed to be cut a lot. That’s not what we’re seeing.”

The Federal Open Market Committee cited “implications of global developments for the economic outlook as well as muted inflation pressures” in making its decision. The FOMC said economic growth in the U.S. is “moderate” and the labor market “strong,” but still opted to ease borrowing costs.

What’s Next?

Traders are going to have to continue to monitor the price action in the Treasury yields. If yields start falling then this will send a signal that the markets think the Fed made the wrong decision.

The Fed, which has been trying to hold inflation at or above 2%, has had trouble sustaining price growth as it approaches this level, despite a healthy economy and low unemployment. That may be a sign that the current level of interest rates may be too high even though the benchmark is well below historical norms.

If Treasury yields decline then this will mean rates need to be lowered in the face of decelerating, but still above-average GDP growth in the U.S. and a gloomier outlook for the global economy due to the trade dispute between the United States and China.

Traders will be fighting history, however, because typically in a period of low levels of unemployment and more modest economic activity, the Fed will hold rates steady.

Some professionals think the Fed was wrong because its actions made the U.S. Dollar stronger and it failed to steepen the yield curve – remember 2-year yields rose and 10-year yields declined.

“There were two components to success:  One was to get the dollar weaker and the other was to get the yield curve steeper. They failed on both measures,” said Jim Caron, Managing Director of Global Fixed Income at Morgan Stanley Investment Management.

“I think the result is that they’re going to cut another 25 basis points again in September, so we’re really talking about semantics,” he added. “What we have to really contend with is that a strong dollar makes you miss on inflation all the more.”