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Long-term interest rates have moved lower as the bond market foresees a weaker economy because of newly unveiled tariffs, despite fears that tariffs will cause higher inflation. In addition, investors often seek haven from stock market drops by increasing their holdings of bonds, driving bond prices up and yields down. The 10-year Treasury yield has moved below 4.0%, and the yield curve has started to invert again, with one-, three- and six-month bill yields still above 4.0%. The low point of the yield curve is three-year notes at 3.65%.
The Federal Reserve left short-term interest rates unchanged at its March 19 meeting because of all this uncertainty. The Fed is in a bit of a pickle. If it is confronted with both 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. The Fed’s preference is likely to stand pat until it sees an economic slowdown. The March employment report was actually pretty robust. At a speech on April 4, Chair Jerome Powell reiterated his belief that the Fed should react only to hard data, which implies not reacting to drops in the stock market or consumer confidence surveys.
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Yet, the Fed may have to cut short-term rates by at least a quarter-point at its next meeting on May 7 if it looks like the economy is headed in the wrong direction, simply to reassure everyone that the central bank is on the job. If the choice comes down to fighting inflation versus supporting a slowing economy, the Fed will likely choose to prioritize the latter and leave the inflation fighting for another day. That’s why investors are expecting it to cut short-term rates between three and four times this year.
The Fed slowed the pace at which it lets Treasury securities mature and run off its balance sheet to $5 billion per month, from $25 billion. This is technically an easing of monetary policy, since it means bond markets won’t have to absorb as many new Treasuries now. That could reduce long-term bond yields a bit. But the Fed left its runoff of mortgage-backed securities intact at $35 billion per month. The central bank would like to get non-Treasuries out of its portfolio as much as possible in order to avoid creating long-term influences on those asset markets.
Mortgage rates have dropped a quarter-point since long-term Treasury yields started easing. 30-year and 15-year fixed mortgage rates should 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 4.6%; BBB-rated bonds are yielding 5.3%, and CCC-rated bonds have surged to 13.9%.
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