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Interest rates would likely be lower than they are today, given an expected slowdown in the economy, if not for fears that tariffs will raise prices and possibly add momentum to inflation. Investors often seek haven from stock market volatility by increasing their holdings of bonds, driving bond prices up and yields down. And the Federal Reserve will often start cutting short-term interest rates if it thinks the economy is on shaky footing.
Last year, the 10-year Treasury yield dropped to 3.6% before the Fed started cutting rates, when it appeared that inflation would be brought under control. However, the 10-year’s yield quickly reversed course after the Fed actually started cutting short-term interest rates, on fears that lower Fed rates could allow inflation to rise again.
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This year, while rates dipped briefly below 4.2% in anticipation of a slowing economy, they soon moved back up to 4.3%. The 10-year Treasury yield will probably stay above 4.0% unless signs of a more severe economic slowdown start to emerge.
The Fed is likely to leave short-term interest rates unchanged at its March 19 meeting because of all this uncertainty. The central bank is in a bit of a pickle. If it is confronted with an economic slowdown and rising inflation at the same time, which should it choose to address? It would normally cut rates to deal with a slowdown, and raise rates to counter higher inflation. So it will wait to make any rate changes, in order to see which problem it should address first. Also, the Fed doesn’t like to move if the direction of either the economy or inflation is unclear, preferring to wait until the data are more telling. The Fed feels that too many zigzags in policy will hurt its credibility.
The Fed will continue to reduce its Treasury securities portfolio. Fed Chair Jerome Powell has emphasized that it is still the central bank’s goal to lower the overall amount of Treasury debt and mortgage-backed securities that it holds, in order to get its portfolio back to a historically more normal level. This gradual reduction in the Fed’s balance sheet could also push yields on longer-term Treasury bonds higher by a small amount, since the market will have to soak up more of Washington’s debt, and investors may demand a higher yield to do so.
Mortgage rates have dropped a quarter-point since long-term Treasury yields started easing. 30-year and 15-year fixed mortgage rates could ease a bit more if the economy weakens further. Mortgage rates are still higher than normal, relative to Treasuries, but whenever the Fed cuts short-term rates again, it will boost banks’ lending margins, which should eventually lower mortgage rates a bit more.
Top-rated corporate bond yields have edged down in tandem with Treasury yields, but low-rated bond yields have jumped with the rise in recession fears. AAA-rated long-term corporate bonds are yielding 4.8%; BBB-rated bonds, 5.4%; and CCC-rated bonds, 12.7%.
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