The Cure for Higher Rates

October 18, 2021

Last Week in Review: The Cure for Higher Rates

Interest rates ticked up just slightly week over week. However, we might have seen a near-term peak in rates. Let’s break down what happened and talk about what to watch for next week.

1. Inflation Remains High

The Consumer Price Index (CPI) for September showed prices are remaining persistently high and challenging the Fed’s notion it will be “transitory”.

CPI showed prices climbed 5.4% year over year, matching the hottest pace in 30 years. The more closely watched Core CPI, which strips out food and energy costs, rose 4.0% year over year. The Federal Reserve has the mandate to maintain price stability (inflation). The Fed’s inflation target is to have core consumer prices run at 2 to 2.5% over the long run, so seeing prices running at nearly double that level is a concern if it is not transitory.

Inflation can increase when people “expect” to pay more. At the moment, both 5-yr and 10-yr inflation expectations are matching the highest levels of 2021. If those inflation expectations rise further, it will put upward pressure on rates. The opposite is true.

2. Fed Minutes Reveal the Taper Plan

Last Wednesday, the Minutes from the previous Fed meeting were released. This is where we get to read the dialogue amongst Fed members and their thoughts on the economy and monetary policy.

The most important takeaway was Fed Members agreeing to a timetable and plan to taper or scale back bond purchases. Here’s what the Fed said back in September:

“The illustrative tapering path was designed to be simple to communicate and entailed a gradual reduction in the pace of net asset purchases that, if begun later this year, would lead the Federal Reserve to end purchases around the middle of next year. The path featured monthly reductions in the pace of asset purchases, by $10 billion in the case of Treasury securities and $5 billion in the case of agency mortgage-backed securities (MBS)”. This is a very gradual scaling back of purchases. It is also important to remember that the Fed will continue to buy bonds daily during and after the taper, with proceeds from their existing portfolio, so this truly is a “scaling” back and not an end to bond buying.

“Participants noted that if a decision to begin tapering purchases occurred at the next meeting, the process of tapering could commence with the monthly purchase calendars beginning in either mid-November or mid-December.” It’s clear the Fed will likely start buying fewer bonds this year.

3. The Cure for Higher Rates is Higher Rates

There were some signs that mortgage-backed securities (MBS), Treasuries, and even bonds abroad hit rate peaks – highlighting that at some point, higher yields attract investors.

For instance, last Tuesday, there was a big 10-year Note auction that showed very high buyer demand. MBSs, last Wednesday, hit the lowest levels since March, but then bounced sharply higher.

Lastly, the German 10-yr Bund touched – 0.08% on Wednesday, which matched the highest yield in over 2 years. Since that time, the Bund yield continued to decline and is currently at – 0.18%. As yields decline abroad, it puts downward pressure on our yields.

Bottom line: We are watching to see if rates might have peaked in the near term, despite persistently higher inflation and the likelihood of the Fed tapering this year.

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