Interest rates are moving higher, and the forces behind the move appear to be persistent inflation and an economy that continues to grow more strongly than many anticipated. Economic growth is generally advantageous, and moderate inflation is a normal feature of a healthy economy. The difficulty is that continued economic strength can sustain demand at precisely the time the Federal Reserve is trying to bring inflation convincingly back toward its 2% target.
This creates an interesting shift in the policy debate. For much of the past year, the Federal Reserve appeared caught in a tug of war between inflation that remained too high and a labor market that appeared increasingly vulnerable. That tension has not disappeared, but labor issues have subsided. The more consequential tug of war today may be between the Federal Reserve's determination to contain inflation and the federal government's enormous, growing need to finance its debt.
See more: Takeaways From the Federal Open Market Committee Minutes
Federal Reserve Chair Kevin Warsh has made price stability the centerpiece of his early tenure. Markets have also been doing some of the Fed's work for it. So much focus centers around the Fed Funds rate controlled by the Fed, however, intermediate and long-term rates have other influential factors that are controlled by the market itself. This part of the curve is rising despite the Fed keeping rate policy steady. Higher Treasury yields generally translate into higher mortgage rates, corporate borrowing costs, and other financing expenses. Those higher costs can moderate borrowing, investment and consumption, and ultimately, help reduce inflationary pressures.
The Fed’s monetary policy is colliding with the government’s fiscal policy. Treasury Secretary Scott Bessent recently announced a significant expansion of the Treasury's buyback program for longer dated securities. The Treasury doubled the size of certain buyback operations involving 10- to 30-year securities to at least $4 billion per operation and increased their frequency. Bessent has subsequently indicated that the size could be increased further. The objective is partly to improve liquidity and potentially curtail the rising long end Treasury rates. This defines the contradiction. The Fed is comfortable allowing the higher market rates to restrain financial conditions, while the Treasury is motivated to prevent long term borrowing costs from getting too high.
Higher long-term Treasury rates flow directly into the broader economy. Mortgage rates are closely connected to longer term yields, meaning rising Treasury rates further challenge housing affordability. Businesses face higher financing costs, and the government's own cost of refinancing its enormous debt load increases. Fiscal policymakers therefore have an understandable incentive to prevent long term rates from becoming excessively restrictive.
The cost of money matters as the size of the government’s debt continues to grow. The gross federal debt recently crossed $40 trillion for the first time, including approximately $32.3 trillion of debt held by the public. The level of interest rates has increasing impact as the nation’s sheer amount of Treasury securities that must be issued, refinanced, and absorbed by investors increases.
Perhaps the most interesting development is that, so far, the bond market does not appear particularly intimidated by Washington's efforts. The Treasury's announcement initially pushed long-term yields lower, but much of that move was subsequently reversed. The 30-year Treasury yield quickly returned to roughly 5.24%, not far from the 19-year high reached immediately before the intervention. The 10-year bond has pushed above 4.7%. Although the Fed can control short term interest rates, it is investors who ultimately influence intermediate and long term rates as they price securities according to inflation expectations, economic growth, supply and demand, fiscal sustainability and the compensation they require for committing capital over long periods. For now, those forces continue to sway yields higher.
The important question may no longer be simply, "What will the Fed do next?" Fiscal policy is also influential. Today, the Treasury market is being pulled by a much broader collection of forces: persistent inflation, stronger than expected economic growth, enormous federal borrowing requirements, Treasury debt management decisions, and the Federal Reserve's commitment to price stability.
That environment may also explain why longer term rates have remained stubbornly elevated despite efforts to push them lower. The Treasury Department can alter the timing and composition of issuance. The Federal Reserve can influence short-term interest rates and financial conditions. But neither institution ultimately has complete control over the price at which private investors are willing to finance the federal government. For fixed income investors, that may be the most important takeaway. Higher yields are creating pressure for borrowers, including the federal government, but they are simultaneously providing investors with levels of income that were largely unavailable for much of the previous two decades.
Rather than focusing exclusively on predicting the next Fed decision or government intervention, investors may be better served by recognizing what the market is already providing: historically attractive income opportunities across portions of the Treasury curve and an opportunity to lock in those rates before the next chapter of the tug of war begins.
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The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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