By Mike Dolan
LONDON (Reuters) – Extreme bond market agitation has put the Federal Reserve in a bind. It can either cool long-term inflation fears or acquiesce to President-elect Donald Trump’s complaints about interest rates being “far too high.”
It can’t do both and will likely opt to tackle the former, potentially setting up a running verbal battle with the White House over the coming year.
The surge in U.S. Treasury borrowing rates in the first weeks of 2025 can no longer be dismissed as just natural ebb and flow around the latest economic updates.
The market is signaling that we’re in alarming new territory that requires caution from the central bank and government alike.
Chief among those red flags is the reappearance of a substantial risk premium being demanded by investors to hold longer-dated U.S. government debt. This gap is typically measured as the extra compensation demanded to lock into a long-term bond to maturity over a strategy of simply buying much shorter-dated debt and rolling it over as events unfold.
The so-called term premium has largely been absent from the market for over a decade. But the New York Fed’s estimate of the 10-year term premium has climbed sharply this year, topping half a percentage point for the first time since 2014.
A 50-basis-point risk premium may not be excessive by historical standards, but it’s 50 bps above the average of the past 10 years.
The term premium’s direction of travel indicates a level of investor uncertainty about longer-term inflation, debt accumulation and fiscal policy that hasn’t been seen for many years. This is almost certainly due to the mix of historically high budget deficits and a still-hot economy with the incoming president’s pledges of tax cuts, immigration curbs and tariff rises.
This uncertainty is showing up in other debt metrics that are increasingly moving independently of the Fed’s policy steer.
The Fed has cut its policy rate by a full percentage point since September, yet the 10-year Treasury yield has risen 100 basis points since then. And 30-year yields are rising even faster, threatening to hit 5% for the first time in over a year – just a quarter point from levels since just before the banking crash of 2008.
While the two-year yield, which most closely reflects Fed policy, has barely moved over the past few months, the two-to-30-year yield curve gap has expanded to its widest since the Fed began tightening policy almost three years ago.
Long-term inflation expectations captured by the inflation-protected Treasury securities market and the swaps market stopped falling in September and have risen back close to 2.5% – about a half point above the Fed’s stated goal.
HAWKISH TURN FOR FED?
If the Fed is losing control of the long end of the bond market, it may be forced to take a more hawkish turn to reassert 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 U-turn on many of Trump’s stated policy promises, it’s entirely possible the Fed may not cut again in this cycle. That’s not apt to please a new president who has already expressed antagonism toward the Fed and questioned the need for its independence.
‘NO IDEA’
Fed Governor Christopher Waller tried to play the middle ground on Wednesday by saying policy remains historically tight, though not enough to force a recession, and that one-off price hits from Trump tariff hikes wouldn’t change the Fed view.
But he also made clear that the Fed – like most bond investors – is now essentially in a guessing game.
While Waller said he doubted the most “draconian” of the new administration’s proposed policies would be implemented, he added that coming up with a forecast for the Fed’s December economic projections was “a very difficult problem.”
“I have no idea what is coming,” he concluded.
He’s clearly not alone. If top Fed officials have no idea what to expect from Trump, then your average bond investors certainly don’t either.
Two scenarios thus seem plausible.
If the Fed were to accelerate rate cuts in line with what Trump appears to want, without a significant shift in economic fundamentals to justify this move, then bond investors would reasonably assume the central bank is not overly concerned about hitting its 2% target.
Bond investors would likely continue to price that risk, “de-anchoring” inflation expectations, as policy wonks say.
But the Fed has routinely stated that containing inflation expectations is one of its primary roles, so it’s hard to imagine it ignoring that development.
And even if Trump’s threatened tariffs do not change the inflation calculus per se, Trump’s plan to roll over tax cuts and tighten labor markets via immigration crackdowns and deportations certainly crank up already-aggravated inflation risks.
If Trump is successful in slashing government spending and federal jobs, he might make some headway in squaring this circle. But few expect this to be either a quick or easy task, especially given that he may not have the 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 deems “far too high” are long-term bond yields.
That way he could allow the Fed do its job and potentially give himself more wiggle room.
But less than two weeks from the inauguration, speculation around what may or may not be coming can and likely will cause considerable market disruption.
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan; Editing by Rod Nickel)
