Monday Momentum: The Real Driver Behind Interest Rates

Apologies for the late email - I had an issue with my service provider and my account got temporarily closed this morning. Great start to a Monday, but I digress!

When the Federal Reserve adjusts its benchmark rate, it’s easy to assume that all other interest rates should follow suit. However, in reality, the relationship between the Fed rate and the actual rates that consumers and businesses experience is much more nuanced. A key player in this dynamic is the 10-year Treasury note, which frequently serves as a more accurate barometer for real interest rates, even as the Fed rate influences it.

How the 10-Year Treasury Note Determines Real Rates

The 10-year Treasury note is a debt obligation issued by the U.S. government that pays interest every six months and returns the principal at maturity. It’s often considered a “risk-free” investment since it’s backed by the government, making it a cornerstone of the financial system. But beyond being a popular investment, the yield on the 10-year note has an outsized impact on real interest rates, such as mortgage rates, car loans, and corporate borrowing costs.

The yield on the 10-year note is driven by supply and demand in the open market. When investors buy more of these notes, prices go up, and yields (interest rates) fall. Conversely, when investors sell, prices drop, and yields rise. This dynamic is influenced by factors such as inflation expectations, economic growth projections, and global economic conditions, often making the 10-year yield a reflection of broader market sentiment about the future.

The Fed’s Influence and the Disconnect

While the Federal Reserve influences short-term rates by setting the Federal Funds Rate, it doesn’t directly control longer-term rates like the 10-year Treasury yield. However, the Fed’s actions can have an indirect impact. For example, when the Fed cuts rates, it typically signals a desire to stimulate the economy, which can lead investors to expect higher future inflation and growth. In response, investors might demand higher yields on the 10-year note, driving up rates.

But this isn’t always the case. Sometimes, the market reacts differently—if investors believe that the Fed’s rate cut signals economic trouble ahead, they may flock to the safety of long-term Treasuries, driving yields down even as the Fed cuts rates. This is why, at times, long-term rates can rise or remain elevated even when the Fed is cutting short-term rates, creating a disconnect between the two.

Factors That Affect the 10-Year Yield Beyond the Fed Rate

1. Inflation Expectations: Investors want to ensure that their returns outpace inflation, so when inflation expectations rise, the yield on the 10-year tends to rise as well, regardless of Fed rate movements.

2. Global Economic Conditions: The 10-year yield is also influenced by global demand. During times of global uncertainty, investors may rush to buy U.S. Treasuries as a safe haven, driving down yields. Conversely, when global growth prospects improve, yields may rise as investors seek higher returns elsewhere.

3. Credit Risk and Lending Practices: When the economic outlook is uncertain, lenders might raise interest rates for consumer and business loans to account for higher default risks, even if the 10-year yield remains low.

4. Supply and Demand for Treasuries: Changes in the supply of Treasury notes (such as increased issuance to fund government spending) can affect yields, as can shifts in demand from investors like pension funds, insurance companies, and foreign governments.

What History Tells Us: Rate Cuts in Soft Landings vs. Recessions

Understanding the 10-year Treasury’s behavior can give us insight into what to expect when the Fed starts cutting rates, particularly in two scenarios: a soft landing or a recession.

- Soft Landing: In a soft landing scenario, the Fed successfully slows the economy to avoid overheating without triggering a recession. Historically, in these cases, the 10-year yield tends to decline modestly as inflation expectations taper off, but it remains relatively stable since the economy is still growing. Real rates may decline slightly, but they typically don’t plunge, reflecting confidence in steady, ongoing economic expansion.

- Recession: In a recessionary environment, the story changes dramatically. When the Fed cuts rates aggressively to combat a downturn, investors often flock to the safety of long-term Treasuries, pushing the 10-year yield significantly lower. During the 2008 financial crisis, for example, the 10-year yield fell from around 4% to below 2% as investors sought refuge. In such scenarios, real interest rates for consumers and businesses tend to drop sharply, reflecting the overall pullback in economic activity.

The chart below (placeholder for graph) illustrates these trends over several past cycles, showing how the 10-year yield reacts differently depending on whether the economy is experiencing a soft landing or slipping into recession.

The 10-Year Note as a Window into the Future

The 10-year Treasury note serves as a crucial indicator of real interest rates, often capturing a more comprehensive picture of market expectations than the Fed Funds Rate alone. While the Fed’s decisions set the tone, the 10-year yield reveals how investors truly feel about the future—whether they're betting on continued growth or bracing for a downturn. Understanding this dynamic can provide valuable insights into where interest rates—and the broader economy—might be headed next.

TL; DR - While the Federal Reserve influences interest rates through its benchmark rate, the 10-year Treasury note often plays a more decisive role in determining real rates for consumers and businesses. The yield on the 10-year is driven by market forces, inflation expectations, and global demand, which means it doesn’t always move in tandem with the Fed rate. In the wake of rate cuts, the 10-year yield behaves differently depending on whether the economy experiences a soft landing or enters a recession. Historically, it declines modestly in a soft landing but drops sharply during a recession, reflecting investor sentiment and economic uncertainty. Understanding this dynamic can offer deeper insights into the future direction of interest rates.

What I’m interested in this week

1. “The Scarcity of the Long Term” by Kevin Kelly

   Kevin is a phenomenal writer with a tremendous body of work. This article explores the limitations of long-term thinking, and how to undertake truly monumental projects that may extend several lifetimes.

2. “China Is Risking a Deflationary Spiral” in The Wall Street Journal

   China used to be a popular target for institutional and hedge fund investing, but their economy has taken a substantial hit in both real numbers and confidence. This article explores the risks of current policy on downstream effects.

3. “Mets Owner Steve Cohen to Stop Trading for His Hedge Fund” in The Wall Street Journal

   Steve Cohen is a legendary hedge fund investor, and his voluntary exodus from trading marks the end of an era. While he will still manage his fund, this is a large changing of the guard on Wall Street.

4. “Fed slashes interest rates by a half point, an aggressive start to its first easing campaign in four years” in CNBC

   By now you are aware of the recent interest rate cut from the fed, but this article explores it a bit deeper along with some implications. There was a lot of debate over how large the cut would be going into this meeting.