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The Federal Reserve held short-term rates unchanged at their July 29 policy meeting, but the long-term bond market was less than happy with Chairman Kevin Warsh’s explanations during the following press conference. Warsh talked a lot about the Fed’s commitment to lowering inflation, but repeatedly cited the recent rise in market interest rates as doing the Fed’s job for it. That suggests, in practice, that Warsh will be OK with a rise in long-term bond rates, as long as short-term rates can stay where they are. Long-term bond investors had hoped for a Fed hike in short-term rates that would lessen the likelihood of future inflation. After they didn’t get that wish, long rates went up as investors assumed that inflation will not be coming down quickly. Warsh also seems to believe that talking tough by itself will reduce inflation expectations, but he has yet to learn the lesson that establishing Fed credibility requires actually raising rates at some point, which his predecessor, Jerome Powell, did in 2022-23.
Upward pressure on long-term bond rates will also continue as long as the Iran war lasts. Ten-year Treasury yields have risen from 4.5% to 4.7% so far in July, and will keep edging upward as long as high crude oil prices threaten to bleed into the rest of the economy, in the form of expensive gasoline and diesel. At the time of this writing, the Iran conflict appears to be widening, with Iran’s proxy militant group in Yemen, the Houthis, now threatening tanker traffic in the Red Sea, and the Iranian Revolutionary Guard acting independently of Iran’s civilian government. A negotiated settlement appears far off. If a cease-fire is reached and doesn’t break down the way the first one did, then the 10-year Treasury’s yield will return to 4.5% or a little less. Without any sort of peace deal, it may approach 5.0% by the end of the year.
Expect the Fed to raise short-term rates by a quarter of a percentage point when it meets again on September 16, unless there is a cease-fire in the Iran war that lasts. Even though Warsh may not want to raise rates, a majority of the 12-member committee will likely overrule him, especially after seeing the fragility of the bond market this week. Certainly, the minutes of the July 29 meeting (to be released on or about August 20) will be interesting to read, and will indicate whether Warsh will go along with the majority sentiment on the committee or seek to impose his will on his colleagues. If the latter, he can probably prevail, given the traditional deference FOMC (Federal Open Market Committee) members normally show to the chair of the Federal Reserve Board. However, that deference may not last if Warsh and the committee come to loggerheads for an extended period of time. The other members will fear that a lengthy period of high oil prices will raise costs for both businesses and consumers, and eventually boost other prices by raising transportation costs, kicking off a new bout of higher inflation.
Mortgage rates are edging up again in tandem with Treasury yields. Thirty-year fixed-rate mortgages are currently around 6.7%. Fifteen-year loans are at 6.0% for borrowers with good credit. Mortgage rates will edge up as long as upward pressure on long-term bond rates remains, but they should remain below 7.0%.
Top-rated corporate bond yields have also been following Treasury yields. AAA-rated long-term corporate bonds are yielding 5.3%, BBB-rated bonds are at 5.6%, and CCC-rated bonds are at 14.6%. CCC-rated bond rates tend to rise when the risk of an economic slowdown mounts, and fall when either the economy strengthens or the Fed cuts short-term interest rates, which eases financing costs for businesses that are heavily indebted.
