Understanding Rising Interest Rates Amid Fed Cuts

It may seem perplexing, but recent events on Wall Street have raised eyebrows. The yield on the 10-year Treasury has surged to over 4.80%, marking its highest levels since 2023, which has triggered anxiety within the U.S. stock market, leading to declines in major indexes.

These shifts in the bond market appear counterintuitive, especially considering that the Federal Reserve has been cutting interest rates three times since September. This situation serves as a reminder that the markets often prioritize the future outlook over current conditions. Investors are showing concern for possibly heightened inflation and a robust U.S. economy, suggesting that further reductions in interest rates may not be needed, which negatively impacts stock prices.

Since September, the Federal Reserve has lowered its key interest rate by a full percentage point. The goal of these cuts is to give the economy some breathing space after earlier efforts had pushed the federal funds rate to a two-decade high with the intention of curbing inflation by gradually slowing the economy.

However, the Fed's influence is limited regarding the interest rates that are impacting the stock market significantly, including the crucial 10-year Treasury yield. While the Fed regulates the federal funds rate— a short-term interest rate that determines what banks charge one another for overnight loans— the 10-year Treasury yield is primarily influenced by investor behavior.

Investors consider the Fed's decisions but focus more heavily on predictions surrounding economic growth and inflation trends. Interestingly, the 10-year Treasury yield began climbing in September, moving from 3.65% at the same time the federal funds rate was starting to decrease for the first time since 2020. This rise in yields occurred even with the Fed lowering interest rates due to an optimistic outlook on economic growth and inflation.

Much of this optimism stems from recent reports, which indicate that the U.S. economy is performing better than expected. However, inflation has proven to be more persistent than initially thought, though recent readings provide some hope, leading to adjustments in Treasury yields.

A historical precedent for this behavior can be seen in late 2018. At that time, the Fed had been raising interest rates since early 2017, which led to a rise in the 10-year Treasury yield. Surprisingly, the yield began to decline before 2018 ended, continuing to drop even after the Fed’s rate hike in December 2018, indicating that the market predicted a pause in rate increases to avoid significant economic pressure.

Political factors can also play a role in these dynamics. For instance, proposals from President Donald Trump to impose tariffs on foreign goods could raise inflation, while his tax cut preferences could lead to increased government debt, which may cause investors to demand higher yields due to heightened risks.

The Federal Reserve has recently signaled a potential slowdown in rate cuts, now projecting only two reductions in 2025 rather than four, leading to speculation on Wall Street as to whether there may not be any cuts at all in that year.

Even optimistic news regarding inflation this past Wednesday did little to calm market fears. Gary Schlossberg, a market strategist at Wells Fargo Investment Institute, commented that it might take several months of reduced inflation for the Fed and the market to entertain the idea of further rate cuts.

rates, inflation, economy