The short-term Fed Funds Rate rose from zero percent in March 2022 to a midpoint of 5.375% in August 2023. The rate on a 30-Year fixed-rate mortgage that was under 3% in late 2021 is now over 7.50%. While the recent consumer and producer price index data shows that inflation has declined, rates keep climbing. A perfect storm of central bank liquidity, government stimulus, and pandemic-inspired supply chain bottlenecks caused inflation to rise to the highest level in decades. Meanwhile, the latest comments from the Fed’s annual Jackson Hole, Wyoming, gathering showed the U.S. central bank remains committed to returning inflation to its 2% target level. Even with the recent declines, the economic condition is sitting at over double that level, meaning one or two more 25-basis point rate hikes could be on the horizon. The iShares 20+ Year U.S. Treasury Bond ETF (TLT) remains in a bearish trend.
TLT has plunged from the March 2020 high
The TLT ETF reflects the path of least resistance of the bond market and long-term U.S. government interest rates.
The chart highlights the 48.9% decline from the March 2020 $179.70 high to the $91.85 October 2022 low. The TLT has made lower highs and lower lows since March 2020. At $95.22 on August 25, the ETF remains not far from the October 2022 low.
Rates may stabilize, but falling could be impossible
The U.S. central bank is committed to returning inflation to the 2% target. While the consumer and producer price index data over the past months has trended lower, inflation remains over double the Fed’s target.
Meanwhile, the short-term Fed Funds Rate has increased from zero in March 2022 to 5.375% in August 2023. The central bank’s quantitative tightening program to reduce its swollen balance sheet has pushed rates higher further along the yield curve, thus the decline in the TLT ETF.
The Fed has reached a point where it is walking a fine line between battling inflation and choking economic growth with further rate increases. The central bank received lots of criticism for waiting too long to address increasing inflation with hawkish monetary policy. The FOMC must now consider that the blame for a recession caused by going too far with rate hikes will fall in its lap. Therefore, the odds now favor pausing and stabilizing the monetary policy-inspired interest rate environment because of the lagged impact of previous rate hikes as they filter through the economy. While rates may stabilize, they will not likely decline much in the current environment.
The U.S. debt makes government debt securities unattractive
The U.S. national debt clock shows the rise to over $32.7 trillion. The 5.375% Fed Funds Rate translates to a more than $1.75 trillion annual debt servicing bill. Even if U.S. government revenues and spending balance, the debt will rise by over $1.75 trillion annually in the current interest rate environment. The debt level suggests that U.S. government bonds have become less attractive investments. Moreover, China had been the leading buyer of U.S. government debt. The bifurcation of the world’s nuclear powers, tensions between Washington and Beijing, and China’s reunification plans with Taiwan could decrease the demand for U.S. debt, pushing bonds lower and interest rates higher.
Geopolitics will keep inflation elevated
While the deteriorating relations between the United States and China could weigh on the bond market, the geopolitical landscape remains a hornet’s nest that causes inflation to increase.
The Russia-China “no-limits” alliance has economic ramifications. Sanctions on Russia and Russian retaliation continue to cause supply chain issues. Russia is a leading energy and agricultural commodity producer. China is the world’s leading raw material consumer. War and geopolitical tensions can distort commodity prices as raw materials are global assets with country-specific supply characteristics and ubiquitous demand.
Meanwhile, the U.S. dollar has been the world’s reserve currency since the end of WW II, making the greenback the dominant foreign exchange instrument for cross-border payments and the commodities pricing benchmark. China and Russia have been working with partners in the BRICS bloc of countries to roll out a BRICS currency with gold backing to challenge the dollar’s dominant role. A BRICS currency could avoid sanctions-related issues for Russia and its allies. The bottom line is a BRICS currency could derail the dollar’s value, leading to rising inflation on dollar-based assets and less demand for U.S. government debt securities.
The odds favor higher, not lower, rates in August 2023
While many market participants believe the Fed may curb its enthusiasm for higher interest rates to battle inflation, geopolitical trends, and the U.S. government debt level could cause the path of least resistance of interest rates to move higher. The decline of the dollar and the bifurcation of the world’s nuclear powers are compelling factors that could make the direction of rates an issue that is above the central bank’s monetary policy reach.
Rate may stabilize, but the odds of any return to the pre-March 2022 environment are slim to none in August 2023. The trend, economic, and geopolitical landscapes support higher instead of lower U.S. interest rates.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
