Quick Bites | Fed cuts, equities rally, but bond markets are nervous

This morning, the Federal Reserve cut interest rates by 25 basis points as expected. Equity markets rallied on the news and US indexes are close once again to all time highs. The Christmas rally looks like it is on course. But bond markets are behaving in a more nervous fashion. In this QB, we look at some of the conflicting messages that bond markets are indicating and explain some of the complex relationships that exist between these two asset classes.

Source: FRED Database, Claude AI

First we look at the US, and then we’ll turn our attention back to Australia.

Source: Torsten Slok, Apollo

Why are long-term interest rates going up when the Fed is cutting rates? Is the market worried about growing Treasury issuance, or about a new Fed leadership effectively raising the inflation target from 2% to, say, 3%, or are there concerns that President Trump will appoint a Fed Chair to replace Jay Powell who is “more compliant” with Trump’s wish for lower rates?

Typically, long and short term interest rates move in the same direction.

Source: Torsten Slok, Apollo

In general terms, long term rates are usually higher than short term rates, reflecting increased risks that may develop over time. The 10-year US Treasury yield is typically higher than the fed funds rate because investors demand extra compensation for lending money for a longer period. This difference is called the “term premium” and reflects uncertainties about future inflation, growth and policy. That is usually the case and typically creates a yield curve that slopes upwards over time.

However, long-term yields sometimes fall below short-term rates (creating a yield curve inversion) when markets expect recession or aggressive future rate cuts.

What are the key determinants of movements in bond yields?

The answer will depend upon the particular circumstances prevailing at the time – but its reasonable to list the major factors as below:

Source: AI, ChatGPT

About a year ago, US long-term interest rates started drifting higher than what would have been predicted by short-term interest rates, inflation data and oil prices.

Source: Torsten Slok, Apollo

This pattern of rising long-term interest rates is unusual when we look at the historical reaction during Fed cutting cycles. The yield curve has continued to steepen, and investors across all asset classes need to try figure out why this might be.

Source: Bloomberg, MacroBond, Apollo

Back to Australia, where bond yields have soared

Let’s shift to Australia, where we recently learned that the RBA is likely to sit on its hands for some time, with the official cash rate at 3.6%. Governor Michelle Bullock indicated in her Tuesday Q&A session that the next move in rates might have to be up rather than down. Unsurprisingly, the ASX reacted with some alarm, the AUD rose against the USD, and 10 Year Australian government bonds have risen sharply since mid-October.

Australian 10 year government bonds have increased by +60bp since mid-October.

Source: Trading Economics

The AUD has surged from US$0.645 to US$0.665 in 3 weeks.

Source: Trading Economics

There is naturally a relationship between US Treasuries and Australian government bond yields. Over the last few decades, Australian 10 yr bond yields have averaged around 4.25% and US 10 yr Treasuries around 3.4%.

Reasons that influence the US–Australia yield relationship include:

• Monetary policy divergence / timing (e.g. Fed cutting while RBA has signalled cuts are done for the moment).
• Country-specific inflation trajectories and expectations (e.g. Australia’s medium-term expectations are showing higher core inflation expectations due to local wage/energy pressures).
• Commodity price shocks and terms-of-trade sensitivity (Australia’s yields are more sensitive to commodity prices like iron ore, gold, and coal because these affect growth, fiscal positions and external accounts. Commodity prices are spiking).
• Global demand for safe/term assets & supply dynamics (e.g. Differential QE/QT, or a surge in US Treasury issuance versus relatively stable Australian issuance changes supply/demand. If global safe-asset demand increases, US yields will fall more than Australian yields.
• Recent market commentary (RBA decisions and global rate moves) suggests monetary-policy divergence and commodity/terms-of-trade moves have been of most importance recently.