Treasury yields jumped as markets priced in one fewer rate cut this year after Federal Reserve chair Jerome Powell discussed the outlook on "60 Minutes." Though Powell taped his interview on Thursday, before Friday's blockbuster jobs report, that fact only reinforced his message that the Fed is in no rush to start cutting.
Why Won't The Fed Cut Rates Now?
The key section of Fed chair Powell's "60 Minutes" interview was his response to Scott Pelley's question: Given progress on inflation, "Why not cut the rates now?"
"Well, we have a strong economy. Growth is going on at a solid pace. The labor market is strong: 3.7% unemployment. And inflation is coming down. With the economy strong like that, we feel like we can approach the question of when to begin to reduce interest rates carefully."
"Moving too soon," Powell said, might halt disinflationary progress, leading to "inflation settling out somewhere well above our 2% target," he said.
Still, Powell's comments were hardly hawkish. He said the Fed's "confidence is rising" that inflation is moving sustainably to 2% and that policymakers are "actively considering" cutting rates.
Powell also noted that signs of weakness in the labor market or "inflation really persuasively coming down" could prompt the Fed to cut rates sooner.
Fed Chair Powell Talks Banking-Sector Health
Powell's "60 Minutes" interview also brought attention to something that largely flew under the radar last week. The Fed policy statement released on Wednesday afternoon omitted what had become customary since the regional banking crisis broke out last spring. The Fed dropped its assertion that "the U.S. banking system is sound and resilient" and its assessment that tighter credit conditions were likely to restrain hiring and inflation.
The omissions surely weren't because the Fed no longer thinks the banking system is strong. Rather, the Fed no longer sees bank fragility as a key concern in setting its policy rate. In other words, credit concerns aren't an obstacle to keeping interest rates high.
In the "60 Minutes" interview, Powell downplayed the risk of bad commercial real estate loans to the broad banking sector.
Powell called it a sizable, but manageable problem, particularly for larger banks.
"There's some smaller and regional banks that have concentrated exposures in these areas that are challenged," Powell said. "This is something we've been aware of for, you know, a long time, and we're working with them to make sure that they have the resources and a plan to work their way through the expected losses."
Some "smaller banks, I suspect, for the most part" may have to be closed or merged out of existence.
Fed Rate-Cut Odds
The odds of a rate cut at the Fed's March 20 policy update fell to 15% on Monday, down from around 50% ahead of last Wednesday's meeting. Markets are pricing in 64% odds of a rate cut by May 1, down from around 90% before the Fed meeting.
Markets are now pricing in a year-end policy rate of 4.21%, up from just under 4% a week ago. That implies a strong chance the Fed will cut by 1.25 percentage points to a range of 4% to 4.25%, but odds of a full 1.5 percentage points in rate cuts have tumbled to 22%.
Treasury Yields And The S&P 500
The 10-year Treasury yield jumped 12 basis points to 4.15%, after spiking by 17 basis points Friday on the January jobs report. Yields had tumbled for much of last year amid regional bank concerns.
The two-year Treasury yield rose 8 basis points to 4.45%. That was the highest since Dec. 12, when tame November inflation data prompted a more dovish Fed tilt.
A bigger-than-expected rise in the Institute for Supply Management service-sector activity index to 53.4 from 50.5 contributed to upward pressure on Treasury yields. Readings over the neutral 50 level signal growth.
The S&P 500 slipped 0.3% in Monday stock market action, but off morning lows. That's after rallying 1.1% on Friday to a record high.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
Fed Ponders Neutral Interest Rate
In discussing the Fed's rate-setting approach, Powell keeps the focus on the Fed's two mandates: 2% inflation and maximum employment. He largely brushes over what may be the key question for investors: What is the neutral interest rate at which the Fed can achieve both goals?
However, the Fed's uncertainty over how soon or deeply to cut rates is really based on policymakers' uncertainty about where the neutral rate lies. The Fed's most recent batch of projections in December showed that, based on the median view of monetary policy committee members, the long-term neutral federal funds rate is 2.5%, or just 0.5% adjusted for inflation. If that's the case now, then the current nominal rate of 5.25% to 5.5% is extremely tight and should be constricting growth.
Yet the economy breezed along at a 4.1% rate in the second half of 2023 and appears off to a solid start this year, raising a question of whether the neutral rate is significantly higher.
The neutral rate matters for stock valuations, because risk-free Treasury yields set the bar for risk-taking. When Treasury yields are very low, we're in a TINA — there is no alternative (to stocks) — environment, such as in 2020 and 2021.
If the neutral federal funds rate is more like 3.5%, then the 10-year Treasury yield, which includes a term premium based on the risk yields might rise further over the coming decade, might be around 4.5%. That matters because analysts use the 10-year yield as the discount rate to value future corporate cash flows. The higher the rate, the lower present value.
