Yesterday, the Fed announced a 25 basis point reduction in the Federal Funds rate target. In the event, the S&P 500 sold off about 3%, while market interest rates spiked upward. Two-year Treasury notes ratcheted up about 12 basis points to 4.35%, while 10 year T-notes rose about 8 basis points to 4.5%.
Let’s put this in perspective by emphasizing bond market behavior. The Fed began its latest easing cycle at the September 18, 2024 Federal Open Market Committee (FOMC) meeting. At that meeting, the FOMC cut the target rate for Fed Funds by ½ percent to 4 ¾ %. Subsequently, at the next 2 meetings, they voted to lower the target rate another ½ %. They did so in two steps for a cumulative reduction of 1% from the September meeting.
The press, including the financial press who ought to know better, insists on referring to these policy steps as the Fed “lowering interest rates”. However, immediately after the Fed began its easing cycle, two-year Treasury yields began their ascent from about 3.6% to 4.32% where they are today. Similarly, ten-year Treasuries began their rise from 3.69% to 4.57% where they are today.
Certainly, some of the prior run-up in bond prices and reduction in yields is attributable to over enthusiastic bond traders looking for more rapid Fed rate reductions. But a rise of anywhere from 72 to 88 basis points in market yields during a time in which the FOMC reduced its Fed Funds target rate by a full 1% is extraordinary.
Which may portend trouble to come.
As it now stands gross Federal debt stands at about $35 trillion. Moreover inflation reports have been hotter than expected for the last several months or so. In addition, the labor market has remained fairly strong, although slightly weaker than it was a few quarters ago.
That said, DOGE or no, entitlements are the driving force behind federal spending. According to the Economic Report of the President, Social Security, Medicare, Medicaid and other Health spending is projected to amount to $4.3 trillion in FY 2025. Add in another $965 billion for interest payments on the debt and we get to about $5.3 trillion, or about 73% of the federal budget. Which, by the way, assumes another $1.7 trillion in deficit spending.
Now assume that the average maturity of the debt is about 4 years. That requires about $8.75 trillion annually to finance maturing debt. Add to that $1.7 trillion in new debt and we have $10.45 trillion in financing every year for the foreseeable future.
How in the world is the market supposed to handle that when rates have already risen about three-quarters of a percentage point while the Fed is nominally easing policy?
The upshot of it is that there is a good case to be made that the financial markets are in for a rough time unless Congress drastically changes the structure of our budgetary woes. That means cutting spending, especially with respect to entitlements.
Neither party has shown any inclination to do that. Trump has promised (for whatever that’s worth) to spare Social Security. The Democrats want to spend even more on entitlements and quite a few of them want “Medicare for All” added into the mix. Certainly a recipe for disaster if ever we needed to be reminded.
Time to be very cautious.
JFB
