Fed Hike Expectations Return as Treasury Yields Rise

The Federal Reserve is back at the center of the market conversation, but this time for a reason many investors did not expect a few months ago. Instead of discussing when interest rates might come down, markets are once again considering whether they need to go higher.

The Fed kept its target range at 3.50% to 3.75% in July. Since then, however, inflation has remained uncomfortable, energy prices have risen, and Chair Kevin Warsh has taken a noticeably hawkish tone.

His Jackson Hole speech changed the mood further. Warsh warned that inflation had not slowed enough and made clear that the Fed still has work to do before it can be confident about returning inflation to its 2% target.

Markets got the message. Expectations for another increase moved sharply higher, with traders now assigning around a 68% probability to a September hike.

Treasury yields followed.

The 10-year yield moved toward 4.8%, putting the closely watched 5% area back within reach. The 2-year yield, which tends to respond more directly to expectations surrounding Fed policy, has also climbed.

For investors, this changes the calculation across almost every major asset class.

Why Are Rate Hikes Back on the Table?

Inflation is the obvious starting point.

July PCE inflation came in at 3.7% annually, while core PCE stood at 3.3%. Neither figure gives the Fed much reason to declare victory, especially when its inflation objective remains 2%.

Energy is making the situation more difficult.

The conflict in the Middle East and concerns surrounding the Strait of Hormuz have pushed oil prices higher. If those prices remain elevated, the effect eventually reaches transportation, manufacturing and other areas of the economy.

This does not mean an oil rally automatically leads to a Fed hike. It does, however, make the inflation picture harder to read.

The economy has also remained resilient enough for the Fed to keep tightening on the table. A sharp economic slowdown would make another increase more difficult. For now, policymakers appear to have some room to concentrate on inflation.

Some banks have already changed their forecasts. Barclays, for instance, expects 25-basis-point increases in both September and December.

That would represent a significant change from the easing expectations that dominated market positioning earlier in the year.

The Bond Market May Be the Bigger Story

Fed expectations explain part of the rise in Treasury yields, but not all of it.

The 10-year Treasury yield reached around 4.81% in early September. That is important because longer-term yields reflect much more than expectations for the next FOMC meeting.

Government borrowing is part of the story. Investors are being asked to absorb large amounts of Treasury issuance while concerns over US deficits remain in the background. At the same time, inflation uncertainty means buyers may demand higher returns before committing money to long-term government debt.

Corporate issuance is competing for capital as well.

Put together, these factors can keep longer-term borrowing costs high even if the Fed eventually becomes less aggressive.

This is where the situation becomes more complicated for markets. The Fed controls short-term policy rates, but it does not simply choose where the 10-year Treasury trades.

A 10-year yield near or above 5% would have consequences well beyond the bond market.

Stocks Have to Compete With Bonds Again

For years after the global financial crisis, investors became accustomed to extremely low bond yields. There were few attractive alternatives to equities. That is no longer the case.

When government debt offers returns approaching 5%, investors can earn meaningful income without taking the same level of risk associated with stocks. Suddenly, a high equity valuation has to be justified against a much more competitive alternative.

Growth companies are particularly exposed to this change.

Their valuations often depend on earnings expected many years into the future. Higher yields reduce the present value of those future earnings, which is one reason technology and other growth-heavy sectors can react badly when Treasury yields jump.

Companies carrying large amounts of debt have a different problem. Debt issued during the low-rate years eventually matures. Refinancing it in today’s market can be considerably more expensive.

None of this guarantees an equity correction. Strong companies can continue performing in a high-rate environment. But investors are likely to pay more attention to cash generation, debt levels and valuations than they did when borrowing costs were close to zero.

A Better Environment for the Dollar?

The dollar has already found some support from the change in expectations.

Higher US yields generally make dollar assets more attractive, particularly when other major central banks are moving in a less hawkish direction.

That makes interest-rate differentials especially important for forex traders.

If US inflation stays high and markets continue pricing further Fed tightening, EUR/USD and GBP/USD could remain under pressure. The picture changes quickly, however, if incoming data weakens enough to reduce the probability of another hike.

USD/JPY deserves separate attention.

Japanese bond yields have been rising too, with the country’s 10-year government bond yield moving above 3%. The yen therefore cannot be viewed purely through the old assumption that higher US yields automatically mean a higher USD/JPY.

The difference between US and Japanese yields will matter more than the direction of either one alone.

Gold Is Caught Between Two Forces

Gold has already lost some ground as Treasury yields and the dollar moved higher.

The relationship makes sense. Gold pays no interest, so holding it becomes relatively less attractive when investors can receive high yields from government securities. Rising real yields can be particularly uncomfortable for the metal.

Yet this is not a simple bearish story.

The same environment producing high yields also contains several factors that can support gold. Government debt is large, geopolitical uncertainty remains elevated, and the Middle East conflict has increased demand for defensive assets.

Gold could therefore remain volatile rather than simply moving lower with every increase in yields.

For traders, real yields and the dollar may provide better signals than nominal Treasury yields alone.

September Could Set the Tone

Attention now turns toward the September 15–16 Fed meeting.

Before then, every major inflation and labor market release has the potential to change expectations. Another strong inflation reading would make a hike easier for policymakers to justify. Weak employment figures could do the opposite.

Oil prices should probably be on that list too. If the current energy shock fades, one source of inflation pressure disappears. If oil stays expensive or rises further, the Fed’s job becomes considerably more difficult.

Then there is the 10-year Treasury yield.

Markets will be watching the 5% area closely. It is partly psychological, but its importance should not be dismissed. Treasury yields feed through to mortgage rates, corporate financing, asset valuations and the broader cost of capital.

For investors and traders, the biggest mistake may be assuming that markets are simply returning to the rate-hiking environment of previous years.

The situation is different now. Government debt is larger, geopolitical risks are elevated and bond yields are being influenced by fiscal concerns as well as monetary policy.

The Fed’s next decision will matter. But what happens to Treasury yields after that decision may matter even more.