An Urban's Rural View

A funny thing happened on the way to lower interest rates: They went higher instead.

The Federal Reserve had lowered its benchmark interest rate by half a percentage point in September, raising expectations that other rates would soon start coming down. (https://www.dtnpf.com/…) Instead, the Treasury's two-year and 10-year notes and the average 30-year mortgage rate have all risen by a half a percentage point or more.

What happened? The short answer is the Fed doesn't have complete control over interest rates. The bond market has a lot to say about them, as well -- longer-term rates in particular, though not exclusively.

The bond market's "say" is a simple reflection of supply and demand. The key is to understand that bond yields and prices move inversely -- when one goes up, the other goes down.

For example: If I buy a bond that yields 5% for $100, I will receive $5 a year in interest. But let's say I am selling the bond to you and because demand is underwhelming and supply is strong, you only pay $90. You now get $5 a year in interest but having paid $90, your yield is 5.55%. (If instead you had to pay $105 for the bond, your yield would be 4.76%.)

What's happening, then, is that while the Fed is now trying to push rates down, bonds are selling off and that's propelling rates higher. The question is, why is the bond market bearish?

There are at least two possible answers.

Some analysts blame what they're calling the "Trump trade." Though the polls are a tossup, the markets think Trump is going to win the presidency. Further, they think a second Trump term will worsen the already bad federal debt trend and bring higher inflation. (https://www.barrons.com/…)

Understand, the markets don't have a political agenda. Bond investors could be wrong about the consequences of a Trump victory -- as well as about the victory itself -- but their forecasts aren't an expression of anti-Trump bias.

Their decisions to buy and sell bonds reflect their estimations of inflation; creditors fear being repaid in devalued dollars. Both candidates have promised inflation-stoking tax cuts and handouts, but economists calculate Trump has promised more. (https://www.crfb.org/…)( https://www.wsj.com/…)

The other explanation for bonds selling off is the economy. The Fed's Sept. 18 rate cut reflected an economy that was barely creating 100,000 new jobs a month. Some analysts were predicting another half-point cut at the Fed's November meeting.

But in early October the Bureau of Labor Statistics reported a 254,000 increase in jobs in September, well above the 12-month average, and BLS revised some of the earlier months upward. (https://www.bls.gov/…) Meanwhile, the inflation rate in September continued its downward march towards the Fed's 2% target but didn't drop as much as analysts expected. (https://www.wsj.com/…)

With those reports, a half-point November cut by the Fed looked less likely. One Fed official even said he was open to skipping a cut in November. (https://www.wsj.com/…)

(The Nov. 1 report of only 12,000 more jobs in October seems likely to be written off as distorted by big storms and the Boeing strike.)

Financial markets are forward looking; they anticipate events. In anticipation of the Fed's September cut, investors had bought bonds, which drove bond yields down. In light of the reports showing a stronger economy and worse-than-expected inflation in September, investors' expectations changed. If the Fed wasn't going to lower rates as much or as fast as expected, markets had to adjust.

It's possible, of course, that the real answer is some combination of Trump trade and expectations of future Fed rate moves. The expectations answer is more conventional. If investors were selling bonds in fear of higher deficits and inflation, you'd have to wonder -- why now? Bond investors have ignored years of multi-trillion-dollar federal budget deficits.

If those deficits are now starting to make bond investors queasy, it would mark a return of what was called the "bond vigilantes." In the early years of the Clinton administration three decades ago, bond investors' concerns about federal spending drove 10-year note yields to 8% from 5.2% in a year.

The administration was forced to work with Congress on plans to rein in spending and years later even produced a budget surplus. Being pushed by the markets to do so caused a Clinton advisor, James Carville, to famously say that if he could be reincarnated as anything, it would be the bond market, so he could intimidate everybody.

For farmers, ranchers and other business borrowers, the big question is where interest rates are going from here. To me, the most likely path is for them to come down, though perhaps more slowly than analysts thought in September.

The U.S. economy is strong -- the Economist recently called it "the envy of the world" -- and inflation is basically under control. Barring the economy growing even faster -- highly unlikely -- and barring inflation resurging -- possible, but not particularly likely -- the current level of interest rates is much higher than current economic conditions warrant.

If I'm right about the economy, the Fed will continue to make cuts -- perhaps only quarter-point cuts, perhaps not every meeting, but over a couple of years its benchmark rate will be closer to 3% than 5%. As the Fed moves in that direction, the markets will eventually fall in line.

Especially if whoever wins the presidency is restrained by Congress, the bond market or a return to common sense from implementing their most inflationary campaign promises.

Urban Lehner can be reached at urbanize@gmail.com

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