The U.S. Federal Reserve has finally begun its interest rate cutting cycle. The 50 basis-point cut to the Fed Funds rate does of course help businesses and borrowers alike. That cut was still months overdue. Because the FOMC has pledged to be completely “data dependent,” Jerome Powell and his team of regional Fed presidents are still rather far behind the curve on the overall economy and where interest rates will be going forward.
This is not a Fed-bashing article. It could be, but what should stand out perhaps more than any other aspect about interest rates is rest of the world (R.O.W.) rates.
After seeing this, it is easy to argue that the United States could have much lower interest rates than at the present time. The premium that the U.S. yields are for investors may not be justifiable for much longer.
Does it mean that long-dates U.S. Treasuries are bargains for buyers? Or does it mean that other government bonds are a total rip-off for buyers? Maybe both, or maybe somewhere in between…
Jerome Powell and the voting members actually only control the shortest interest rates. The Fed Funds and the Discount rate are their target. The inflation target of 2.0% (or up to 2.5%) has merits of course, but the Fed’s dual mandate for creating an atmosphere to foster full employment can be a little tricky when managing short-term interest rates and simultaneously selling off longer-dated agency and mortgage debt.
Tactical Bulls is looking beyond short-term rates here. The long-term Treasury yields, without considering the Fed’s buying and/or selling Treasuries and agency debt, is a market-driven force. The Treasury, not the Federal Reserve, is the entity that decides how many billions of dollars it sells at monthly Treasury auctions.
The U.S. Treasury’s “Debt to the Penny” was listed as $35.324 trillion as of 9/24. That may only be $28.19 trillion held by the public, but the all-in government outstanding debt is what matters the most. And the higher interest rates of the last year-plus now compounds interest to make that total deficit grow only faster.
The debt to the penny crossed $35 trillion for the first time on July 26 — and it only took since January 4 for the last $1 trillion rise. This rapid rise in the deficit is from the last two years of runaway spending long after it was needed to help the economic recovery, and (again) higher Treasury yields only make this worse.
Where investors need to consider their longer-term decision at this moment in time is the yield premium that is still available to investors who buy long-term Treasury debt. The U.S. dollar is still the world’s reserve currency. How long that lasts is up for a fair debate that is going to require some real honesty. And as long as the U.S. dollar is the global reserve currency, the yield premium available for U.S. debt investors is considerable.
The argument of an undeserved or unneeded U.S. yield premium does just sort of smooth over inflation, deficit spending, the reserve currency status, stable international markets and more. That is undeniable, and it has to be part of the larger argument. But does it have to be part of a larger argument in the next year?
According to the WSJ’s government bond yields table, the only major economic powers that have to pay higher yields for 10-year government notes are the United Kingdom, Australia and New Zealand. The current U.S. Treasury yield is 3.79% for the 10-year note. Here is the current layout of major economic powers for their 10-year yields:
- Germany 2.185%
- U.K. 4.017%
- Japan 0.831%
- Australia 3.950%
- China 2.089%
- New Zealand 4.245%
- France 2.976%
- Italy 3.479%
- Spain 2.954%
European nations in the E.U. get the umbrella effect of larger more prosperous nations giving cover to the weaker nations. It still makes you wonder where borrowing rates would have to be for the weaker links in Europe if it was not for the EU/ECB umbrella. Germany’s 10-year may be 161 basis points lower in yield (1.61% lower), but Italy and Spain also have lower yields than the U.S.
The United Kingdom has been in a realm of its own since Brexit, so maybe that why yields are still a tad higher than the U.S. That being said, how high would yields by in Spain or Italy (and Greece!) without that EU/ECB umbrella.
China has had a weak economy on its own for a growing period of time. Its 10-year yield of 2.09% are basically 170 basis points less. That means that for every $100 million in a static currency scenario that China gets to pay $1.7 million less in interest than the U.S. has to pay.
And Japanese 10-year yields have been low for an entire generation now. Japan was effectively the last major economy to exit the negative interest rate policy. Now the Bank of Japan’s new head has signaled more rate hikes ahead are likely. Whether that means the 10-year yield will rise much is debatable, but Japan gets to pay only 0.83% per year to anyone buying their 10-year paper.
There is nearly a tie on the CME FedWatch tool whether the U.S. Fed Funds rate will come down another 25 or 50 basis points at the November 7, 2024 FOMC meeting. Still, the current Fed Funds range of 4.75-5.00% now has the highest probability (50.5%) of being down to 4.00-4.25% at the December 18 FOMC decision — with the other rate challengers at 3.75-4.00% (21.8%) and 4.25-5.00% (27.8%).
Now go all the way out to the end of 2025. The two highest probabilities in the CME FedWatch tool have Fed Funds predicted to be 2.75-3.00% (27.5%) or 3.00-3.25% (26.9%). Whether short-term Treasury yields back at 3% means that longer-term rates will be down handily remains to be seen.
Whether the U.S. ends up in a soft landing or an economic recession is going to probably have the largest impact on long-term Treasury yields. Hopefully we are not dealing with yet another international crisis at that time. The U.S. is already on the path to have accumulated a deficit of $40 trillion by the end of 2025.