How Inflation Expectations and Treasury Yields Affect Fed Rate Decisions

# Basic question re: Fed interest rate tightening and rising interest rates


# Basic question re: Fed interest rate tightening and rising interest rates












February 2/8/2018 - context in case the question is still around beyond today: the stock market has been falling for almost a couple of weeks in the midst of fears of overheating of the economy (increased salaries with full employment), concern about Fed rate hikes accelerating; and a huge blow to the fiscal deficit resulting from recently enacted tax cuts. So bizarre world of fiscal stimulus in a full employment economy coupled with progressive monetary tightening, already underway under Janet Yellen.

Today the US stock markets started and moved lower in the morning as the 10Y Notes yields climbed higher. I read the following on Bloomberg:

> The 10-year Treasury yield resumed its march toward 3 percent, touching a four-year high and stoking angst that the Federal Reserve will be forced to tighten.

Question:

If the rates go up as a result of fiscal deficit concerns and expectations of inflation, isn't that a way of "organically" tightening? Doing the work of the Fed, as it were... If the rates just go up on their own accord, as a result of expectations that borrowing will be more difficult with a government financed on deficits, and reducing its tax revenue on top, as well as a result of concerns about inflation, isn't the market dynamics doing the job of the Fed?

Ultimately, does the quoted sentence above make sense?

If the 10Y Note climbs spontaneously beyond 3 percent, isn't it more likely that the Fed reconsiders tightening further, i.e. rising interest rates?

## Answer by Helin (score 1, accepted)

https://quant.stackexchange.com/a/38145

> If the rates go up as a result of fiscal deficit concerns

The impact of fiscal deficit is likely to be a very small factor (if at all) behind the recent selloff in bonds. If deficit is a major driver behind yield levels, we should've been rapidly rising yields around the world for many years. Think about Japan, which has one of the highest govt debt to GDP ratios, has a 10-year bond yield of just 0.08%.

> isn't that a way of "organically" tightening

The rise in yield can be considered as a tightening in financial conditions, which do have a negative impact on economic conditions going forward (e.g., the higher yield will flow through to other debt markets, constraining credit expansion).

> as a result of expectations that borrowing will be more difficult with a government financed on deficits

As mentioned, the concern for "borrowing difficulties" is likely negligible. Price changes when market expectation changes. The Fed, in its projection materials, has implied three hikes for 2018. The market, on the other hand, priced in less than two hikes for 2018 due in no small part to the lack of inflation pressures. As incoming data suggests growing inflation pressures, the market is now perceiving that the Fed may indeed hike three times or more, and is adjusting the forward curve accordingly.

> does the quoted sentence above make sense?

I don't think the quote means to say that the market is forcing the Fed to hike. I think it's trying to convey that the market is now perceiving that the growing inflation pressure will force the Fed to hike. Because of this change in perception, they're repricing bonds, because their prior assessment of inflation path might have been wrong.

> If the 10Y Note climbs spontaneously beyond 3 percent, isn't it more likely that the Fed reconsiders tightening further, i.e. rising interest rates?

It has indeed happened that rising yields become such a concern for central banks that they either pause their hiking activities or outright reverse course and lower interest rates to create a more accommodative monetary environment. As it stands, the market is still gauging the reaction function of the Fed under a new chair.

## Answer by Yannick (score 0)

https://quant.stackexchange.com/a/38137

Short answer: The FED controls the short-term interest rates while inflation controls the long-term interest rates. If the 10Y or 30Y move higher, it means inflation is picking up either because of good economic conditions or depreciation of the dollar. In this case the FED will hike further in order to slow down the economy or the depreciation of the dollar, impacting the short term rates (and having an impact on long-term rates). The debt burden will linger on companies which in turn will affect the US stock market.