The Federal Reserve and Germany cause turmoil in interest expectations.. What is the story?

2023-11-29 12:43:00

Tuesday’s trading was very slow, with most of the action in the bond market, with yields falling by 15 basis points, steepening the yield curve with the 10-year Treasury yield spread rising by about eight basis points to -42 basis points.

Very large falls in inflation in Germany helped push yields down by seven basis points on the day, which helped push down the two-year yield in the US. The US two-year index also took another step lower yesterday when Chris Waller indicated that the Fed may cut interest rates next year if US interest rates continue to fall.

5-minute chart of US 2-year returns

Why is the Fed talking about cutting now?

This may seem logical, because if inflation rates fall and federal funds rates do not fall, monetary policy will become more restrictive, with real interest rates rising. So, one would expect the Fed to cut interest rates as inflation declines. Of course, the question is how much it reduces inflation and by how much it reduces it.

How will markets react to the Fed’s hints?

If the curve continues to steepen, an index is likely to experience a sell-off. The curve has been driving stocks for a while now, and while stocks were not sold off yesterday, the steep yield curve will make it very difficult for stocks to rise.

2-hour chart of 2-10-year US returns

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