After Fed’s 0.5% Rate Cut : Why U.S Treasury Yields Up & Japan’s Yen Down ?

(feat. Jerome Powell, Neutral interest rate, inflation, Dollar, Yen)

As the effects of the Fed’s Significant 0.5% rate cuts are gradually becoming clearer, let’s break it down :

1. On October 11, 2018, U.S. stock markets suffered five consecutive days of significant declines.

2. The plunge was so severe that even the White House spokesperson felt compelled to declare, “There is no crisis.”

3. As U.S. markets plunged, global markets in Europe and Asia followed: UK’s FTSE 100 lost 12.5% for the year, China’s Shanghai Composite fell 25%, and Japan’s Nikkei also saw sharp declines.

4. The trigger for this market turmoil was a statement by Fed Chair Jerome Powell.

5. During a Fed press conference, Powell stated that the U.S. was “a long way from neutral interest rates.”

6. Powell’s comment sent shockwaves through the market, but on November 29, at the New York Economic Club, he made a significant “pivot.”

7. Powell shifted his “tone” that day.

8. He altered his stance from “a long way from neutral” to “interest rates are just below neutral.”

9. Following this dovish pivot, U.S. markets quickly began to recover.

10. This shows how sensitive markets are to the concept of the neutral rate.

11. The neutral rate refers to the ideal interest rate that promotes strong economic growth and full employment without causing inflation or deflation.

12. If rates rise above the neutral rate, the Fed enters a tightening phase, but when rates reached the neutral point, it halts further hikes.

13. Powell’s initial statement in early October implied that the Fed was committed to strong rate hikes.

14. In contrast, his late November remark suggested a slowdown in the pace of rate increase, and the market took it as a positive sign.

15. During the Fed’s press conference on September 19, 2024, Powell mentioned the neutral rate once again.

16. At first, his remarks seemed unremarkable, something like “we’re not returning to zero rates”

17. However, when viewed through the lens of the ‘neutral rate,’ this comment can be interpreted differently.

18. It became clear that his statement could carry a more significant meaning.

19. If the neutral rate has risen considerably, the room for rate for rate cuts to reach it would also be smaller.

20. A smaller-than-expected rate cut impacts many areas.

21. One major area affected is U.S. Treasuries.

22. Existing Treasuries, issued at higher rates, become more valuable when the Fed cuts rates, causing newly issued bonds to offer lower yields.

23. For example, if new Treasuries offer a 2% coupon while you hold bonds yielding 4%, the value of those 4% bonds increases.

24. However, if the newly issued bonds offer a 3% yield instead of 2% – by smaller-than-expected rate cut -, the “relative” value of your 4% bonds drops.

25. A smaller rate cuts leads to decline in the value of existing Treasuries, which naturally pushes their yields higher.

26. A higher neutral rate means the pace of narrowing interest rate differentials between the U.S. and Japan slows down.

27. This is likely one of the reasons the yen experienced a temporary dip overnight.

28. Powell did not disclose an exact figure for the neutral rate and stated that it’s “uncertain.”

29. Saying he doesn’t know the precise neutral rate is both true and misleading.

30. The neutral rate is theoretical, meaning it’s difficult to pinpoint an exact value.

31. Therefore, Powell’s claim about “not knowing the exact rate” is technically accurate.

32. However, the Fed must have an internal estimate of the neutral rate to guide their policy, even if it’s not disclosed publicly.

33. This is why Powell’s statement can also be seen as misleading.

34. Central banks, including the Federal Reserve, use models to estimate the neutral rate.

35. For example, the Fed uses models like the Holston-Laubach-Williams (HLW model, R-star) to estimate the real neutral rate, which recently was estimated at 0.5%.

36. The real neutral rate doesn’t account for inflation, so to get the nominal neutral rate, the Fed adds its inflation target (around 2%).

37. When adding inflation, the “nominal neutral rate” might range between 2.5% and 3.5% based on different estimates.

38. Various models may give different estimates, and central banks often take an average or a median value for policy making.

39. In the U.S., if the neutral rate is estimated at 3.0%, it suggests that interest rates may gradually moved toward this level to balance growth without sparking inflation.

40. Policymakers might also exclude extreme estimates and use a median to fine-tune their target.

41. The Fed currently has the federal funds rate at 5.25%, significantly above the neutral rate, indicating that policy is still restrictive.

42. If the neutral rate is around 3.0%, the Fed would likely adjust rates downward over time, as hinted in their dot plot projections for 2024.

43. While Powell hasn’t revealed the exact neutral rate, analyst suggest the Fed may consider a neutral rate slightly higher than past estimates, given the improved productivity growth in the U.S. economy.

44. This suggests that upcoming rate cuts may be smaller than markets initially hoped.

45. Powell’s cautious tone on the neutral rate, combined with lower-than-expected rate cuts in the Fed’s dot plot, has left markets somewhat disappointed.

Let me be clear

One liner comment

Feels like handling out Hallween candy to a kid, and they give you the side-eye because they expected the king-size bar. Looks like the market’s got some pretty high hopes!