Oct 5, 2023 - Economy

Why rate hikes might start to pinch

Data: Federal Reserve; Chart: Axios Visuals
Data: Federal Reserve; Chart: Axios Visuals

For the last year, there has been a bit of a mystery: How is it that the Fed could raise interest rates as rapidly as it has yet cause so little damage to the economy? One answer is that medium- and longer-term rates haven't risen nearly as much as the short-term rate controlled by the Fed.

Why it matters: That has changed in recent weeks, with longer-term rates rising abruptly — which, in turn, could mean that higher interest costs start to bite across more corners of the economy than they have to date.

State of play: The yield curve has been highly inverted over the last year, with longer-term rates lower than their short-term counterparts. Bond investors bet that the Fed's rate hikes would prove short-lived and that rates would settle back at lower levels before long.

  • That has acted as a lid on rates for much of borrowing that affects the economic activity — causing many of the rates that actually matter to rise by significantly less than the Fed's policy rates.
  • Companies usually fund long-term investments with long-term debt, for example. Car loans are typically for three to five years; mortgages, for 30 years.
  • Low longer-term rates have also kept a floor under the stock market and other asset prices.

By the numbers: At the recent peak in May, the rate on three-month Treasury bills was 1.9 percentage points higher than for 10-year Treasuries.

  • That helps explain, for example, why investment-grade corporate bond yields have risen only about 1.8 percentage points between March 2022 and late July 2023, a span in which the Fed has raised its target rate by 5.25 percentage points.

Yes, but: Now long-term rates are rising and the yield curve is un-inverting. The three-month yield is now only 0.9 percentage points above the 10-year, and the spread has been narrowing fast. Bond investors no longer see the high rate environment of 2023 as a short-term situation.

What they're saying: "For most of the time since the Fed started raising rates we had a very unusual environment," Deutsche Bank chief U.S. economist Matthew Luzzetti tells Axios, "in which the market consistently priced relatively soon and steep rate cuts."

  • "This no doubt helped to keep medium and longer term rates — especially real rates — more subdued and helped to support financial conditions," he says.
  • The Fed's communications and the economy's resilience "have led this all to revert to a more normal landscape," Luzzetti adds.

The bottom line: In 2022 and much of 2023, the yield curve gaveth. Now the yield curve is set to taketh away.

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