Last week there was a fascinating public conversation between bond traders and their chief psychologist, Jerome Powell.
Mr. Powell’s primary job is to be the Chairman of the Federal Reserve. In this position he is responsible for maintaining full employment and a growing economy while keeping the flames of inflation near his self-designated 2% annual target. This has not been an easy job lately.
The tools at Mr. Powell’s disposal are broad and varied. However, his most powerful tool is the words he chooses to describe his views on the economy and the future direction of interest rates. The value of and interest rate on trillions of dollars of debt are heavily influenced by his words. Thus, bond traders are always trying to parse Mr. Powell’s linguistics for any subtle clues about the future.
Mr. Powell is generally very guarded in revealing what he is really thinking, and occasionally bond traders read too much into his nuanced responses. Or maybe he is using their obsession with his every word to manipulate them into doing his bidding to further his goals. That is the psychological game that makes the financial markets so unpredictable.
Last week, Mr. Powell had the following to say in his prepared statement:
“Financial conditions have tightened significantly in recent months, driven by higher longer-term bond yields, among other factors.”
Indeed, the yield on a 10-year Treasury bond had increased from a mere 3.30% in April to 4.98% in October. Bond traders have been expecting interest rates to stay higher for longer based on Mr. Powell’s words.
These increased interest rates forced 30-year mortgage rates up toward 8% — clearly a headwind for the housing market. They also increased the borrowing costs for companies who need to borrow to expand their businesses or refinance maturing debt.
From Mr. Powell’s viewpoint, the economic brakes of higher long-term interest rates reduces the need to raise short-term interest rates at this time.
He expounded on his prepared statement in answering a reporter’s question last week:
“The tighter financial conditions we’re seeing from higher long-term rates but also from other sources like the stronger dollar and lower equity prices could matter for future rate decisions, as long as two conditions are satisfied. The first is that the tighter conditions would need to be persistent and that is something that remains to be seen. But that’s critical, things are fluctuating back and forth, that’s not what we’re looking for. With financial conditions, we’re looking for persistent changes that are material. The second thing is that the longer-term rates that have moved up, they can’t simply be a reflection of expected policy moves from us that we would then, that if we didn’t follow through on them, then the rates would come back down.”
But bond traders did not focus on this portion of Mr. Powell’s words. Instead, they focused on his seeming dismissal of some words from September that indicated a strong inclination to raise interest rates one more time.
Bond traders interpreted this dismissal to mean that the Federal Reserve is likely done raising interest rates. And immediately, traders drove long-term interest rates down to 4.57% on the 10-year Treasury.
Just to recap the psychological interest rate scenario currently afoot:
- Powell states that consistent higher long-term interest rates are slowing the economy, so there is no need to raise interest rates last week.
- Bond traders interpreted Mr. Powell’s comments to mean the Federal Reserve is done raising short-term interest rates and celebrated by buying bonds (reducing long-term interest rates).
- Bond traders’ buying spree means that long-term interest rates may no longer meet Mr. Powell’s criteria of being consistently higher, increasing the odds that the Federal Reserve will raise interest rates in the future.
Since bond traders likely missed Mr. Powell’s key point last week, we may hear some additional words from the Federal Reserve in the coming days re-emphasizing that they are open to additional interest rate hikes as needed. Bond traders will likely react accordingly.
Let the psychological interest rate games continue.
Quote of the week: Howard Marks: “Experience is what you got when you didn’t get what you wanted.”
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