What The Fed's September Comments Mean For The Future Of The Treasury Market

Among the economic headlines for investors heading into Q4 is the drop in government bond prices and the corollary increase of treasury yields to new recent highs. Spurred by the Fed’s first ever September interest rate hike, as well as indications of another increase before the year is out, the interest rate markets have suddenly been sent scrambling with the realization that the 10-year economic boom period might finally be taking a backseat to inflationary concerns.

The recent moves in the 10-year and 30-year treasury market’s prices and yields are particularly interesting given that they are coming at an unique economic and historic moment. The underlying narrative from the Fed is that rates are being stepped up to a target of around 3-3.5 percent by 2020 as the economy chugs along at around 3 percent GDP. Critically, the Fed’s September commentary dropped the word “accommodative” with respect to the body’s position on supporting economic growth, something that has been a feature since the 2008 crash.

First, while inflationary signals like high GDP and low unemployment motivated recent rate hikes, Fed chair Jerome Powell also cited persistently low wage growth, a relatively flat yield curve and uncertainty surrounding the effects of President Trump’s trade wars as headwinds to growth. While this does not diminish the likelihood of a fourth increase in 2018, it does cast doubt on how aggressive the body might be should these trends prove more troublesome than they now seem.

However, more puzzling to the future of the U.S. monetary picture is that almost one year has passed since the Federal Reserve ended its program of quantitative easing, which it implemented after the 2008 financial crisis to inject liquidity into market when interest rates were near zero (hence “accommodative”).

While the Fed anticipated the end of the debt program, it’s long-term plan to shrink its balance sheet was less thought out. Now, with QE well in the rearview mirror and growth starting to pick up, the Fed is struggling to find the best way to gradually shrink its balance sheet by balancing how many millions of the maturing bonds it will reinvest versus how much it will let disappear. Letting too much cash disappear could be overly deflationary, while holding on to too much could be harmful if inflation does start peaking.

These factors could prove overwhelming if they all begin to come to a head toward the end of the year. And, with futures lower on both the 10- and 30-year notes, investors should keep a close eye on the numbers coming out of the U.S. in coming months.