Source: Wall Street News

The Federal Reserve has entered a rate-cutting cycle, but US Treasury yields have surged sharply; what exactly is the market pricing in?

On January 8, Nobel Prize-winning economist Paul Krugman published an article stating that despite the Federal Reserve starting to cut rates, long-term rates (such as 5-year auto loans, 10-year CSI Enterprise bond Index, and 15 or 30-year mortgage rates) have risen, which is contrary to the direction of changes in short-term rates (like the Federal Funds rate). This phenomenon is unprecedented.

Krugman proposed that the rise in long-term interest rates, such as the 10-year U.S. Treasury yield, may reflect a terrifying, quietly spreading doubt that Trump actually believes the crazy things he says about economic policy and might put them into practice.

Krugman stated that the response from the bond market indicates that investors have begun to foresee inflation pressures brought on by these policies, thus changing expectations for future Federal Reserve policies:

If he truly implements any significant part of these policies, the Federal Reserve will clearly have to pause further rate cuts. In fact, the Federal Reserve may feel the need to raise rates again.

However, given that Trump may demand the Federal Reserve to continue cutting rates, Krugman believes that if the Federal Reserve ultimately yields to this pressure, it will mean that rates will rise further, rather than decline:

Many economics students know that Richard Nixon forced the Federal Reserve to maintain low interest rates before the 1972 election, despite the increasingly severe inflation problem. Ultimately, this led to a surge in both inflation and interest rates.

If bond investors start to worry about the madness of Trump 2.0, why are Stocks still rising?

Krugman provides two possible explanations:

The first is that stock investors and bond investors are not the same; the former are more emotional and more easily influenced by sentimental factors. Everyone knows about meme Stocks; they have surged due to the frenzy on Social Media. As for meme Bonds, I haven't heard of them.

The second explanation is that the recent rise in the stock market is actually quite narrow. It can be said that this is mainly due to the impact of AI. The Dow Jones Industrial Average can be seen as a representative of the non-AI economy, and it has almost completely erased the gains from the Trump effect.

The following is the full text of the article:

The Federal Reserve responded to the surge in inflation from 2021 to 2022 by raising interest rates significantly. Even by the end of 2023, when inflation was nearing the Fed's (arbitrary) target of 2%, the Fed still maintained high interest rates for a long time. However, the Fed finally began to cut interest rates last September. So, is there any relief felt?

Probably not. The Federal Reserve only controls short-term rates—actually, its target is the federal funds rate, which is the overnight loan rate between Banks. However, the rates that truly impact people's lives are long-term rates: for example, 5-year auto loans, 10-year CSI Enterprise bond Index, or 15 or 30-year mortgages. And an interesting thing has happened: these long-term rates have actually risen. Since the Fed began cutting rates, the benchmark 10-year U.S. Treasury yield has risen roughly in line with the decline in the federal funds rate.

This kind of divergence is unprecedented. As Thorsten Slok from Apollo Company pointed out in a report on Tuesday, typically, when the Federal Reserve lowers interest rates, long-term rates at least decline somewhat.

Therefore, the situation we are seeing now is very special. Slok said:

The market is telling us something, and for investors, understanding why long-term rates rise when the Federal Reserve lowers interest rates is crucial.

So, I believe there are three main explanations here:

The market is the market, and that’s just how it is.

It is difficult to squeeze out that last bit of inflation.

The bond market is starting to question whether Trump truly believes in the crazy things he says about economic policy and whether he will put them into practice.

I intend to advocate for the third viewpoint, although I am also aware that this may just be overly optimistic.

There is no contradiction in the differences between short-term and long-term interest rates, even if they change in opposite directions. Investors choosing between short-term and long-term investments are actually always betting on future interest rates. For example, by the end of 2024, the average interest rate for a one-year fixed deposit is expected to be 1.76%, while the interest rate for a three-year fixed deposit is 1.43%. Does this mean the one-year fixed deposit is more attractive? If it is anticipated that future interest rates will decline, it is instead better to lock in that 1.43% rate as soon as possible.

So, if long-term interest rates rise while the Federal Reserve is cutting rates, it may be because investors have raised their expectations for future Federal Reserve rates. Why would they do this?

One should not assume that the market is always correct, especially not believe that the market knows things that others do not. John Maynard Keynes once made profound and elegant observations about the 'fragility' of market pricing, arguing that the market often overlooks long-term factors. Although most of his discourse applies more to the stock market than the bond market, since the bond market tends to be more prudent. However, bond investors are also betting on future macroeconomic trends, and the information they have is no different from that of any economist who knows how to use FRED (Federal Reserve Economic Data).

Nevertheless, I still hear a lot of discussions about how cooling inflation might be much easier than predicted by many economists—let's not forget those who claimed that controlling inflation would require a 6% unemployment rate for five years—but now there are views that inflation might stagnate between 2.5% and 3%, rather than falling back to 2%. Is this statement accurate?

Well, I have spent quite a bit of time reading how economists are trying to analyze data and estimate potential inflation rates; is it 2.8%? 2.4%? Or 2.1%? I have done some of this work myself. But now I feel like we are like soothsayers looking for omens in the entrails of sacrificed goats.

However, it is worth mentioning that enterprises, especially those that are closer to the market than ordinary people, do not seem to believe that cooling inflation will stagnate in the short term:

This leads to the third point: the rise in long-term interest rates, such as the 10-year treasury yield, may reflect a terrifying, quietly spreading suspicion that Donald Trump actually believes the crazy things he says about economic policy and may put them into practice.

Look at the developments in recent days. Jeff Stein from The Washington Post reported that people close to Trump plan to introduce a series of relatively limited strategic tariffs, rather than the destructive trade war he has consistently promised against all countries; Trump quickly responded by posting that this report is 'fake news' and claims he does indeed intend to impose high tariffs on every country and all goods.

In short, the source says: "Trump is not as crazy as he appears to be." Trump responds: "Yes, I am!"

Then, to eliminate any doubts that he might be more rational than he seems, Trump held a press conference where he seemed to propose annexing Canada, possibly invading Greenland, seizing the Panama Canal, and renaming the Gulf of Mexico as 'Gulf of the USA.' This morning, CNN reported that Trump is considering declaring a national economic emergency—in a country with a low unemployment rate and very low inflation!—as an excuse to significantly raise tariffs.

What does this have to do with interest rates? Economists almost unanimously agree that Trump's proposed high tariffs, tax cuts, and massive deportation of illegal immigrants will exert significant inflationary pressure, although this effect may not be immediately apparent; regardless of what Trump does, inflation may remain relatively low for much of this year. However, if he implements any significant parts of these policies, the Federal Reserve will clearly have to pause any further rate cuts. In fact, the Federal Reserve might feel it necessary to raise rates again.

Indeed, Trump—who just declared yesterday that interest rates are still too high—would certainly explode if the Federal Reserve raised rates. In fact, he might demand that the Federal Reserve continue to lower rates. And considering that almost all significant Institutions in the USA are flattering themselves, can we really be sure—really, really sure—that the Federal Reserve can maintain its independence? Can we imagine Federal Reserve officials hiding in their offices when MAGA supporters storm the Eccles Building? Actually, we can imagine that.

But if the Federal Reserve ultimately succumbs to this pressure, it means that interest rates will rise further, rather than fall. Many economics students know that Richard Nixon forced the Federal Reserve to keep interest rates low before the 1972 election, despite the increasingly severe inflation problems. Ultimately, this led to a surge in both inflation and interest rates.

But you may wonder, if bond investors begin to worry about Trump's 2.0 insanity, why are Stocks on the rise?

I can provide two possible explanations. The first is that stock investors and bond investors are not the same; the former are more emotional and more easily influenced by irrational factors. Everyone knows about meme Stocks that surge due to the frenzy on Social Media. As for meme Bonds, I’ve never heard of them.

The second explanation is that the recent rise in the stock market has actually been quite narrow. It can be said that this is mainly due to the influence of AI. The Dow Jones Industrial Average can be seen as a representation of the non-AI economy, which has nearly eradicated the gains from the Trump effect: well, I don’t want to push this issue too far, partly because I don't want to fall into the trap of motivated reasoning. Those of us who fear Trump's rise certainly hope he is punished in the market, but we should not expect to see results immediately. The consequences of Trump's economic delusions may take years to manifest.

However, even if the Federal Reserve lowers interest rates, an increase in rates may already be an early signal of future trends.

编辑/jayden