Interest Rates Remain Unchanged as Fed Stays Guarded

As expected, the Federal Reserve (Fed) left the federal funds rate unchanged on July 31. The short-term target lending rate remains at a 23-year high of 5.25% to 5.5%, where it’s been for more than a year.

This backdrop continues to create a mixed bag for Americans. Yields on savings accounts, CDs and other cash equivalents have lingered at historically attractive levels. But interest rates on credit cards, auto loans, mortgages and other lending have climbed to multiyear highs.

Slowing but Still-Sticky Inflation Has Kept Fed Cautious

Inflation has been the stumbling block for policymakers, who late last year forecasted three interest rate cuts in 2024. Now, with five months remaining, Fed officials were non-committal, refusing to comment on the futures market’s expectation for a September rate cut.

While Fed Chair Jerome Powell touted progress on fighting inflation, he reiterated the Fed’s need for more confidence that the 2% target inflation rate is attainable. He also highlighted steady labor market conditions, which have allowed the Fed to better balance its inflation and employment mandates. These observations suggest inflation is getting closer to a level at which the Fed can confidently cut rates.

Annual core inflation (personal consumption expenditures) was 2.6% in June, unchanged from May, down from April’s 2.8%, and still shy of the Fed’s 2% target. The core Consumer Price Index (CPI), which excludes food and energy prices, was 3.3% (annualized) in June, while headline CPI was 3%. Additionally, the U.S. economy staged a second-quarter rebound, advancing 2.8% annualized, compared with 1.4% in the first quarter.

We believe slowing inflation will coincide with a broader pullback in U.S. economic growth. Consumers, the largest contributors to gross domestic product (GDP), face challenges amid slowing wage growth and depleted excess savings. Additionally, the labor market’s strength appears to be abating, as the unemployment rate ticked higher in June for the fourth consecutive month.

Global Central Bank Policies Diverge as Fed Pauses

After cutting rates a quarter point in June, the Bank of Canada eased again in July, diverging from its U.S. and European peers. The European Central Bank also eased in June, but it left rates unchanged in July as core inflation stayed above target. Like the Fed, the Bank of England has yet to cut rates, worried about lingering inflationary pressures.

The Bank of Japan also pursued a different course, as inflation in June hovered at its highest level since February. Central bankers lifted the nation’s key short-term interest rates a quarter point on July 31 to 0.25%. They also announced plans to reduce their monthly bond buying to pursue a more normal monetary policy.

Soaring Federal Debt Likely to Push Treasury Yields Higher

While inflation and other cyclical factors remain near-term drivers of interest rates, we expect secular trends to push longer-maturity interest rates higher over time.

Cyclical inflation and job market data typically determine Fed policy, which largely influences the movement of short-maturity bond yields. While Fed policy may also affect longer-maturity bond yields, secular factors typically have a greater influence on those yields over time. One of the biggest factors — U.S. government spending — points to a likely period of relatively higher bond yields down the road.

Our intermediate-term outlook calls for inflation to ease, interest rates to fall and economic growth to slow. Once these datapoints bottom, we believe fiscal policy will emerge as a dominant force pushing interest rates up again.

Larger fiscal deficits and higher interest rates go hand in hand, given the need for increased U.S. Treasury issuance to fund the government’s deficit spending. And to keep investors interested in purchasing longer-maturity Treasuries over time, Treasury yields must remain at attractive (higher) levels.

So, while “higher for longer” has described the interest-rate backdrop, it also depicts the sustained upward trend in the nation’s debt.

Bond Market Volatility Rises Amid Debt Concerns

Mounting national debt has several implications for fixed-income markets:

• Volatility. The growing federal budget deficit combined with uncertainty about Treasury issuance suggest bond yields may remain volatile in the near term. The current debt limit suspension will end January 1, creating a trigger for that uncertainty. And the current volatile political climate likely won’t help.
  

• Upward pressure on yields. We believe cyclical factors, such as labor market, economic growth and inflation data, will lead to lower bond yields in the near to medium term. However, we also expect fiscal largesse to be an unavoidable long-term structural factor keeping yields relatively higher than they were in the past two decades.
  

• Inflation. Continued government spending growth represents a structural driver of inflation.

Debt Ceiling Uncertainty Has Fueled Bond Market Volatility

As Figure 1 illustrates, when the U.S. government consistently complied with the debt ceiling, bond yields generally trended lower. Investors knew what to expect in terms of Treasury issuance, even before the 2008 Financial Crisis.

But as the government swayed to larger deficits, it started regularly breaching the debt ceiling. Accordingly, higher-than-expected Treasury issuance emerged, and bond yields steadily climbed higher. In fact, when the government began ignoring its debt ceiling in 2013, the multiyear downward trend in the 10-year Treasury yield ended.

Cyclical factors, particularly inflation, contributed significantly to the recent spike in yields. And these factors will likely contribute to the pending near-term decline in yields. Nevertheless, soaring federal debt will create a floor for yields, in our view.

A Balanced Bond Portfolio Could be Crucial Amid Economic Uncertainty

We believe this outlook presents potential opportunities for investors to balance exposure to duration, or interest-rate sensitivity. Despite the Fed’s extended pause, policymakers have indicated that their next policy move will be to cut interest rates.

In this environment, exposure to intermediate-duration (three to five years) bonds may deliver attractive yield and total return potential. When the Fed starts cutting rates, yields should broadly decline, and bonds with longer durations should experience greater price appreciation potential than shorter-duration bonds. But in an era of heightened bond yield volatility, especially given the upcoming January 1 debt ceiling flashpoint, extending duration too far may be risky.

At the same time, we believe high-quality, shorter-duration (less than three years) bonds may help deliver balance to fixed-income portfolios. With the Fed’s target lending rate topping 5%, shorter-duration bonds currently offer attractive yields, in our view.

Furthermore, adding these investments now provides potentially desirable exposure to the Fed-sensitive part of the yield curve. Falling short-maturity yields would coincide with additional total return potential.