The Bond Market Is Calling 'BS' on the Fed and More Cuts Won't Help

The Fed cutting interest rates over the past few months has been a contentious topic of late. 

After remaining on hold for most of this year, the Fed decided to cut the federal funds rate by 50 BPS in September. At the time, it made sense as the data over the summer saw the U.S. economy starting to roll over as each metric came in much softer with inflation readings staying low, too. 

This gave the Fed the justification it needed to cut, but something changed once the Fed cut back in September. Since then, the U.S. bond market has not been a happy camper. 

Yields on the back end of the curve have been rallying ever since. The yield on the U.S. 10-year rallied from lows of 3.65% all the way to 4.45% as the bond market seems to be convinced day by day that the Fed is about to make a policy mistake. So, why is the U.S. bond market so nervous? 

We know U.S. debt interest expense is averaging about a $1 trillion per year, and it is projected to hit about 25% of total tax revenue by the end of the next decade. Over the last 105 days, we have added about $1 trillion more to the bill. This rate of growth is unsustainable, and to service it will be even more so. The Fed needs to cut rates to lower this expense for them, but also to boost the value of the bonds held to maturity at the banks to allow them to be free to lend out more than just park their losses at the Fed at zero. They also need to cut rates to boost demand for the small- to medium-sized business as well as consumer mortgage demand. 

But this is not possible as inflation is still quite a way above their 2% target. The last year has seen inflation fall nicely but now the PCE and CPI 12-month inflation do appear to be flattening out in recent months. The Fed's target is in terms of core PCE, which in October printed at year over year 2.8% versus the core of 3.3%. 

The other issue is that each month-over-month CPI print over the past four months has been around 0.3%. As Jerome Powell says, "There is still work to be done." 

The labor market has cooled off a bit, but it is not troubling in any way as unemployment is averaging closer to 4.1% to 4.2%. Hardly worrying. As the data post-summer has stabilized, why then is the Fed so eager to cut, even after the data has turned? 

One can argue that the 50 BPS cut was necessary to boost confidence in the market in September, but after the 25 BPS cut in November, some bullish analysts are beginning to question the validity of a 95% probability of a 25 BPS rate cut on Wednesday, especially as inflation is showing signs of being sticky in the last few months.

This is exactly what is worrying the bond market, as we saw the three-month/10-year yields invert last week for the first time since November 2022 when the equity market rally started. The more that the Fed cuts to front run a weak labor market or to get "ahead" of the soft data, the more the bond market will get upset as it risks inflation getting out of hand when fiscal spending clearly is not being reined in as yet. 

There is a lot being bet on AI, growth and productivity to boost the debt-to-GDP ratio by getting the latter up in time before the former becomes a problem. Time shall tell, but we know that the Fed follows the bond market, and it has since last year. 

For now, the bond market is calling "BS" on the Fed and its cuts. Powell may be boxed in for a cut this December, but it will certainly be delivered with a hawkish message, as they wish to have a clean slate as the Trump term starts and to see how the economy does together with the fiscal restraint that has been promised. If not, they risk annoying the gods of the bond market, and that is never a good course of action.

At the time of publication, Bengali had no positions in any securities mentioned.