The bond market helps solve the Fed’s interest rate dilemma

The bond market may be doing the Fed’s work for it.

The central bank wants to keep rates steady in the face of the Iran conflict, which has sent oil prices up more than 50% and raised expectations of inflation in the next few months.

Meanwhile, the markets are already overpriced. In the first month of the war, global short-term and long-term bond yields rose sharply, as bond markets reset them to reflect a rapidly changing view of higher inflation.

“The unprecedented disruption to oil supplies caused by the war in the Middle East has undermined investors’ initial expectations for inflation and central bank actions,” Ed Yardeni, president and chief investment officer of Yardeni Research, wrote in a research note.

Read more: How oil prices move in your wallet, from gas to groceries

Fed Chairman Jerome Powell said this week that the central bank has been looking at the normal trend of oil prices and taking no action, but policymakers cannot ignore that the increase in oil prices comes at a time when inflation has remained above the Fed’s 2% target for five years now.

At least one Fed member suggests that the Fed should not focus on oil price shocks. “With inflation already hot, now is not the time to think that the price boost from high oil prices will be temporary,” Kansas City Fed president Jeff Schmid said in a speech on Tuesday.

An important task for the Fed is to carefully monitor inflation expectations and whether the series of inflation with this epidemic, rates, and now oil can lead the general public – businesses, price beaters and households – to start expecting higher inflation over time.

Read more: How jobs, inflation, and the Fed are all related

“We’re taking that very seriously,” Powell said Monday. “Inflation expectations seem to be more stable in the short term, but still, that’s another thing, because ultimately we’re going to face the question of what to do here.”

Bond yields already reflect higher borrowing costs

If long-term inflation expectations rise above the 2% target, the Fed will need to move.

But it may be necessary. The central bank raises and lowers its interest rate – the rate at which banks lend overnight, which in turn influences all other financial system rates to lower or stabilize borrowing costs. The effects of low prices boost economic growth, while high prices reverse it.

Now, the yield on the two-year Treasury – the best barometer of where investors think the federal funds rate is going – has risen to 3.8% and was as high as 4% on March 27, compared to 3.4% before the war started in Feb. 28. It is above the current federal funds rate of 3.7% to 3.5%.

Read more: What is a 10-year Treasury bond and how does it affect your finances?

Yields on the 10-year Treasury rose from 3.96% to a high of 4.4%, breaking through the significant 4.25% range seen since last August.

The 10-year Treasury rate tracks 30-year fixed rates, which have risen more than half a point on average since hitting a three-year low three weeks ago. According to Zillow’s mortgage marketplace, the national 30-year fixed rate is 6.47%.

“This trend, unfortunately, is not consumer friendly right now,” Bankrate senior economist Mark Hamrick said, noting that mortgage rates in the “middle 6” are now a reality for many home buyers, and other types of debt, such as auto loans and credit cards, are also high.

“Buyers hoping for relief from high-interest debt will have to wait a little longer, as the Fed continues to hold off on the Iran-related energy crisis,” Hamrick said.

‘It’s wait-and-see’

Before the conflict, the bond market was pricing two to three of 25 this year. Last week, all those discounts were off the table, and there was a 40% chance of a hike in October. As of Tuesday, the market has not priced in any prices this year, according to CME Futures.

At the Fed’s policy meeting a few weeks ago, officials were on the lookout for one rate cut this year. But Powell cautioned against putting too much stock in interest rate estimates and noted that, in general, most Fed members have penciled in small gaps since December.

The possibility that the Fed’s next move may be a rate hike also came up at the meeting, as it did at the January meeting, according to Powell. He said that most Fed officials do not see that as their top priority but it is not off the table.

Read more: How the Fed’s rate decision affects your bank accounts, loans, credit cards and investments

Now the central bank expects that the inflation on the subject and the “base” base, which does not include unstable energy and food prices, to rise to 2.7%, from the previous forecast of 2.5% for the year.

New York Fed President John Williams, who is vice-chairman of the Federal Open Market Committee and holds a permanent seat, said on Monday that he expects rising oil prices to push up overall inflation in the coming months but the effects should change little later this year, assuming oil prices ease after hostilities end.

He also noted that the war itself could cause inflation to rise by raising average costs and commodity prices and reducing economic growth.

Markets are also concerned about growth. The yield differential – the difference between the yield of short-term government debt and long-term government debt that reflects how markets see the direction of economic growth – has decreased.

“That happens when there’s a concern about growth,” said Wil Stith, Wilmington Trust’s senior bond manager. “If oil stays high and the price increases, you will start to see the damage that is needed.”

Stith described the bond market’s reaction as “moderate,” noting that the focus is on inflation, inflation expectations, and possibly a weak economy, especially the growing concern about unemployment.

A strong February jobs report, due out on Friday, could send yields on the two-year Treasury back to 4%. But a weak report would mean that it is trading at yields close to 3.6%.

“It’s a wait-and-see how long this conflict lasts,” Stith said. “It’s a matter of waiting and seeing how much this conflict affects US inflation.”

Yardeni asserted that the American economy is at greater risk of an oil crisis today than in 2022. Yardeni noted that after the 2022 Russian invasion of Ukraine, which sent oil prices up to $ 145 per barrel, the impact of the pandemic was still circulating in the economy, the labor market was historically strong, wage growth was strong.

Today, low- and middle-income families are under pressure, and labor market conditions have fallen sharply.

“In this region, the constant fear of oil supply is decreasing rapidly,” said Yardeni. “The need for low oil prices to damage demand. In this situation, the Fed’s response should be nothing.”

Jennifer Schonberger is a former financial journalist who covers markets, economics and investing. At Yahoo Finance he covers the Federal Reserve, Congress, the White House, the Treasury, the SEC, the economy, cryptocurrencies, and the intersection of Washington policy and finance. Follow him to X @Jenniferisms and further Instagram.

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