In recent months, the Federal Reserve has reduced its policy rates by 100 basis points, leading to significant movements in the Treasury market, particularly a rise in the 10-year Treasury yield by 87 basis points. Following a recent 25 basis point cut, the Fed indicated a future marked by higher inflation and anticipated elevated “longer-run” policy rates. This shift in guidance suggests that the Fed is projecting only two additional rate cuts in 2025, a stark reduction from the previous forecast made just three months prior. The sentiment garnered from Fed Chair Jerome Powell’s comments during a press conference seemed to indicate a shift away from further rate cuts next year, implying that the Fed’s so-called “recalibration” of monetary policy might already be concluded despite the brief rate reductions.
The response to this information among investors was immediate and impactful, as evidenced by the S&P 500 index declining by 3%. This sentiment is also reflected in the Treasury market, particularly in the behavior of short-term yields, which have remained steady without any noticeable decrease throughout the week after the Fed’s announcement. The short-term yields have now settled around the Effective Federal Funds Rate (EFFR) of 4.33%, echoing previous rates before the Fed’s recent actions. This development indicates that participants in the market currently do not foresee further rate cuts in the immediate future, marking a stark contrast to previous pricing patterns observed in recent months.
The yield curve has noticeably adjusted, completely un-inverting in recent weeks, with short-term yields remaining stable while longer-term yields have increased. Specifically, yields for 1-year and longer maturities experienced rises, with the 10-year Treasury yield climbing to 4.52% and the 30-year yield reaching 4.72%. The chronological analysis of the yield curve—taken on key dates across 2024—reveals an inversion that began in July 2022 as aggressive Fed rate hikes drove short-term yields higher at a faster pace than their long-term counterparts. Despite this inversion earlier in 2023, the yield curve has now returned to a flatter profile, indicating a 22-basis point spread between the 2-year and 10-year yields.
Although the current yield curve is flat, there are indicators that suggest it could undergo a normalization process where the spread between the 2-year and 10-year yields expands, either through falling short-term yields or rising long-term yields—or a combination of both. In conjunction with the Fed cutting its target range for the EFFR to 4.25% to 4.50%, Treasury yields have responded variably across different maturities. For example, 1-year Treasury yields are slightly beneath the EFFR, while 10-year and 30-year Treasury yields are notably above it, indicating a potential divergence in market expectations regarding future rate movements.
The implications of these financial dynamics are significant, particularly in the residential mortgage market. Following the Fed’s initial rate cuts in September, the average 30-year fixed mortgage rate has surged to approximately 7.04%, up from 6.11%. This increase correlates closely with the rise in the 10-year Treasury yield, reflecting a wider spread that has emerged recently between the two rates. This phenomenon suggests that households may need to adjust to higher mortgage rates, reminiscent of levels seen prior to the financial crisis of 2008. The persistent upward trend in mortgage rates favors a cautious approach for home buyers and investors as they navigate this changing landscape.
In summary, as the Federal Reserve moves through its process of monetary policy adjustments, market expectations are shifting significantly with implications for both the Treasury and mortgage markets. The combination of altered projections for future rate cuts, the re-inversion and flattening of the yield curve, and surpassed mortgage rates all serve to paint a complex and uncertain picture for the economy moving forward. Investors will need to adapt accordingly to navigate these evolving scenarios, highlighting the ongoing importance of observing the Fed’s monetary policy actions and market reactions as this landscape continues to develop.