The US Federal Reserve raised its main interest rate by three-quarters of a percentage point, the biggest increase since 1994. Data suggests the Federal Open Market Committee (FOMC) may need to act more decisively to slow consumer and business spending and the job market to bring prices under control. The raise was widely as per investors’ expectations and led to a rally that offered a respite from the swift increase in Treasury yields. Two-year yields, which are highly sensitive to monetary policy changes, dropped as much as 24 basis points, with similarly large moves seen in the 10-year securities. Yet the market has been extremely volatile, and many investors say 10-year yields are likely to push up to levels not seen since 2010. While the Fed Chairman Jerome Powell said that the bank is “absolutely determined” to keep inflation expectations anchored to 2%, a bond market proxy for the anticipated five year inflation rate edged up as much as 9 basis points to 3.03%.
While yields have marched higher this year, the gap between short- and long term rates has narrowed or inverted periodically, indicating expectations that rate hikes will slow growth or lead to a recession as early as next year. The Fed now see the federal funds rate they control rising to 3.4% by the end of this year and 3.8% at the end of 2023. That’s well above the 2.5% rate they reckon is neutral for the economy, neither spurring nor restricting growth and compares with the current fund’s rate target of 1.5% to 1.75%.
Powell added that it was too soon to declare victory over inflation that has surged to a four-decade high or even see much evidence of an economic slowdown that would contain it. Policy makers indicated that the Fed’s benchmark rate will end next year at 3.8% from 2.8% that was previously anticipated. Such a path would almost certainly increase what are already Treasuries’ worst losses since at least the early 1970s, and spur another leg of higher rates. Two- and ten-year Treasury yields now around 3.3% and 3.4%, respectively, have tended to peak in line with the Fed’s benchmark, making investors eye 4% as the next milestone.
Investors should look to accumulate investment grade bonds with short durations in the current situation for relative safety.