US Market: Fed holds rates steady, but bond investors remain concerned over inflation

The US Federal Reserve kept interest rates unchanged on Wednesday, as expected, but failed to reassure bond investors concerned about persistent inflation, government borrowing and the outlook for longer-term Treasury yields, Reuters reported.

The central bank upgraded its assessment of the US economy, describing growth as strong, compared with the “solid” expansion cited at its September meeting. It also pointed to robust investment and job gains that were keeping pace with workforce growth.

Read more: Global Market: China’s yuan hits four-year high against dollar after Fed holds rates


However, the Fed’s decision to hold rates steady despite the strength of the economy left investors uncertain about how much further monetary policy might need to tighten and whether inflation would return to the central bank’s 2% target.

The uncertainty comes as Treasury yields have climbed this year to their highest levels in two decades, putting pressure on government bond prices and raising borrowing costs across the economy.

Read more:Global Market: South Korean shares fall 2% as Samsung Electronics slides after earnings

Treasury yield curve steepens after Fed decision

The US Treasury yield curve steepened following Fed Chair Kevin Warsh’s press conference, with longer-dated bonds coming under particular selling pressure. The spread between two-year and 10-year Treasury yields widened to as much as 34.1 basis points after flattening over the preceding weeks, Reuters reported.

Investors interpreted Warsh’s remarks in different ways. His reluctance to commit to a specific path for future policy moves reduced some expectations of further rate increases, while his suggestion that the Fed’s previous rate hike was beginning to take effect indicated that financial conditions had tightened.

Nevertheless, yields rose across much of the curve, particularly for maturities of five to seven years and beyond. The pressure reflected concerns extending beyond the immediate direction of interest rates to include inflation uncertainty and the US government’s fiscal outlook.

Byron Anderson, head of fixed income at Laffer Tengler Investments, said the bond market selloff reflected concerns that the Fed could struggle to raise rates much further without triggering problems elsewhere in the economy, Reuters reported.

Inflation and fiscal concerns weigh on long-term bonds

Investors are increasingly concerned that resilient economic growth and persistent inflation could complicate the US fiscal outlook. If inflation remains elevated, the Fed may have limited room to cut interest rates when economic conditions weaken, potentially keeping Treasury borrowing costs high.

Anders Persson, chief investment officer for global fixed income at Nuveen, said stronger economic growth could fuel inflation and make concerns about the fiscal deficit and its long-term management more significant, according to Reuters.

The pressure has been particularly pronounced in longer-dated Treasuries, where investors face greater exposure to changes in inflation expectations and interest rates over time.

When uncertainty increases, investors may demand additional compensation for holding bonds with longer maturities. This can push yields higher and prices lower, even without a corresponding increase in expectations for the Fed’s policy rate.

The additional compensation, known as the term premium, reflects the risks associated with holding longer-term debt. Concerns about government borrowing requirements and the sustainability of the fiscal outlook can drive this premium higher.

Persson said concerns about pressure on the US fiscal outlook were a key factor behind the weakness at the longer end of the Treasury yield curve, Reuters reported.

Markets weigh possibility of further rate hikes

Financial markets are already pricing in another rate increase in December, while expectations of additional hikes next year have added to uncertainty over the policy outlook, Reuters reported.

The prospect of higher rates for longer challenges both bond and equity investors. Higher Treasury yields can make government debt more attractive relative to riskier assets, while increasing financing costs for businesses and households.

Longer-term borrowing costs are also influenced by inflation expectations, government debt issuance and the compensation investors require to hold bonds over extended periods. These factors can keep yields elevated even if the Fed leaves its benchmark rate unchanged.

Questions emerge over Fed’s assessment of growth

The Fed’s more optimistic assessment of the economy also drew scrutiny from market participants, who questioned whether recent indicators justified the upgrade.

Brian Jacobsen, chief economic strategist at Annex Wealth Management, pointed to a slowdown in the trend of weekly payroll gains reported by ADP since the September meeting. He also noted that the Atlanta Fed’s GDPNow estimate had moderated from much stronger levels, Reuters reported.

The changing data have raised questions about whether the economy is as broadly resilient as the Fed’s assessment suggests.

Andrew Hollenhorst, chief US economist at Citigroup, said Warsh was overstating the breadth of strength in the economy, potentially leaving the central bank more vulnerable to weaker-than-expected economic data, according to Reuters.

Such uncertainty could affect shorter-dated Treasury yields, which are particularly sensitive to changes in expectations for monetary policy. However, longer-dated bonds face additional pressure from concerns about inflation, fiscal deficits and the risks of holding government debt over time.

The divergence highlights the challenge facing bond investors: while the Fed is waiting for further evidence before adjusting policy, markets remain concerned that inflation and borrowing pressures could keep long-term interest rates elevated.

(Disclaimer: This article is based on inputs from agencies. These do not represent the views of The Economic Times)