Yields look biased downward

Indications are that the US economy continues to expand—despite the short-term headwind of the government shutdown—spurred by consumer spending and strong business investment. Meanwhile, Treasury yields remain choppy, moving marginally with each day’s shift in Fedspeak and market narratives. As we await resumption of official data releases, however, available signs still point downward for interest rates.  

Positive wealth effects from rising house prices and buoyant financial asset valuations are supporting consumption from upper-income households, which have represented a larger share of overall consumer spending in recent years. In fact, the Atlanta Fed’s GDPNow series currently projects Q3 GDP at 4.0%. However, the recent lack of official government releases that normally inform this statistic increases the risk of overestimation. 

For the fourth quarter, the Congressional Budget Office has stated that a one- to two-month federal government shutdown likely will depress GDP by 1-2 percentage points, but with nearly all of that ‘loss’ being recovered in coming quarters. Meanwhile, accumulating anecdotal evidence and private sector labor indicators suggest that job creation remains weak. While US inflation remains elevated, partly boosted by the gradual effect of tariffs, it appears to be more an ongoing Federal Reserve (Fed) concern than a negative in the consensus view. 

The Fed delivered its anticipated 25 basis point (bps) cut to the federal funds rate at its October meeting, accompanied and complicated by Chair Powell’s comment that another ease at the December Fed meeting is “not a foregone conclusion.” This comment likely reflects a wide range of near-term policy views among the Federal Open Market Committee (FOMC) members and a purposeful attempt to diminish market expectations of a December ease.

Yields rose following Powell’s comments, indicating he succeeded in partially repricing interest rate markets. That said, the Fed’s effort to balance downside risks to employment and upside risks to inflation suggests any signs of further labor market weakness through spreading layoffs or slower job creation will keep the Fed in easing mode. In addition, the anticipated Trump appointment of a dovish successor to Powell as the next Fed Chair reinforces the downward market expectations for the path of the fed funds rate. 

In contrast, overseas, the European Central Bank appears to be done lowering interest rates, as eurozone economic growth likely will accelerate on recent monetary easing and planned fiscal loosening in Germany. In Japan, the change in political leadership reinforces the Bank of Japan’s bias to hold policy steady to see if inflation will cool without further action. China continues to export disinflation as its domestic demand remains weak, its domestic overcapacity produces deflation, and its government priority is fixed on bolstering manufacturing for export-led growth.

The Federated Hermes Duration Committee reestablished a small lean long in anticipation of labor market weakness persisting and intensifying, outweighing inflation concerns. We remain cautious, however, amid prospects of a delay in Fed easing arising from a divided FOMC and the solid momentum of US economic expansion.