Author: Mike Dolan
LONDON (Reuters) – Extreme turmoil in the bond market has put the Federal Reserve in a bind. It can either ease long-term inflation fears or acquiesce to President-elect Donald Trump’s complaints that interest rates are “far too high.”
He can’t do both and will likely choose to tackle the former, potentially setting up an ongoing verbal battle with the White House over the next year.
The sharp jump in the US Treasury borrowing rate in the first weeks of 2025 can no longer be dismissed as just the natural ebb and flow of the latest economic updates.
The market is signaling that we are in alarming new territory that requires vigilance from both the central bank and the government.
Chief among these red flags is the re-emergence of the significant risk premium required by investors to hold long-term US government debt. This gap is usually measured as the additional fee required to lock in a long-dated bond to maturity versus a strategy of simply buying debt with a much shorter date and paying it back as events unfold.
The so-called forward premium has been largely absent from the market for more than a decade. But the New York Fed’s estimate of the 10-year premium has risen sharply this year, topping half a percentage point for the first time since 2014.
A risk premium of 50 basis points may not be excessive by historical standards, but it is 50 bps above the average over the past 10 years.
The direction of the term premium indicates a level of investor uncertainty about longer-term inflation, debt accumulation and fiscal policy that has not been seen in many years. That’s almost certainly due to a mix of historically high budget deficits and a still-hot economy with the incoming president’s promises to cut taxes, limit immigration and raise tariffs.
This uncertainty is reflected in other debt indicators that are increasingly changing independently of the Fed’s policy management.
The Fed has cut its benchmark rate by a full percentage point since September, but it has risen by 100 basis points since then. And 30-year yields are rising even faster, threatening to hit 5% for the first time in more than a year — just a quarter point from levels just before the 2008 banking meltdown.
While the two-year yield, which most closely mirrors Fed policy, has barely moved in the past few months, the gap in the two-year to 30-year yield curve has widened to its highest level since the Fed began tightening policy nearly three years ago.
Long-term inflation expectations, captured by the inflation-protected government securities market and the swaps market, stopped falling in September and rose again to near 2.5% – about half a point above the Fed’s stated target.
HAWK HAS TURNED FOR FEDA?
If the Fed is losing control of the long-dated bond market, it may be forced to take a sharper turn to reaffirm its commitment to achieving its 2% inflation target on a sustained basis.
This means that, barring a sharp cooling of the economy or a significant reversal in many of Trump’s policy promises, it is entirely possible that the Fed will not cut again this cycle. This does not sit well with the new president, who has already expressed antagonism to the Fed and questioned the need for its independence.
‘NO IDEA’
Fed Governor Christopher Waller tried to play a middle ground on Wednesday, saying that policy remains historically tight, though not enough to trigger a recession, and that a one-time drop in prices due to Trump’s tariff hike will not change the Fed’s stance.
But he also made it clear that the Fed — like most bond investors — is now essentially in a guessing game.
While Waller said he doubts the most draconian policies proposed by the new administration will be implemented, he added that forecasting the Fed’s economic projections for December is “a very difficult problem.”
“I have no idea what’s next,” he concluded.
Apparently he’s not alone. If top Fed officials have no idea what to expect from Trump, then surely neither do your average bond investors.
Therefore, two scenarios seem likely.
If the Fed were to accelerate rate cuts in line with what Trump seems to want, without a significant shift in economic fundamentals to justify the move, then bond investors would reasonably assume that the central bank is not overly concerned about hitting the 2% target.
Bond investors would likely continue to value that risk, “draining” inflationary expectations, as policy experts say.
But the Fed has routinely said that curbing inflationary expectations is one of its primary roles, so it’s hard to imagine it ignoring the development.
Even if Trump’s threatened tariffs don’t change the inflation calculus per se, Trump’s plan to extend tax cuts and tighten the labor market by cracking down on immigration and deportations is sure to add to already worsening inflation risks.
If Trump succeeds in cutting government spending and federal jobs, he could make some headway in square footage this round. But few expect that to be either a quick or easy task, especially given that he may not have enough votes in Congress to actually pass large parts of his agenda.
Perhaps the incoming president could help the Fed — and himself — by making it clear that the borrowing rates he considers “too high” are long-term bond yields.
That way, he could let the Fed do its job and potentially give himself more wiggle room.
But less than two weeks from the inauguration, speculation about what may or may not come can and likely will cause significant market disruption.
The opinions expressed here are those of the author, a Reuters columnist.
(author: Mike Dolan; editing: Rod)
