According to Blockworks, despite the Federal Reserve's recent rate cut of 50 basis points in September, financial conditions have tightened rather than loosened. This development may seem counterintuitive, especially for those not deeply familiar with fixed income markets. Here's a breakdown of how this situation unfolded.
When the Federal Open Market Committee (FOMC) lowers interest rates, they specifically reduce the interbank overnight rate, known as the federal funds rate. However, the FOMC has less direct control over longer-term interest rates on the yield curve, which are more influenced by market forces. Through guidance on the path of rates and a summer of weak economic data, the market anticipated one of the most aggressive rate-cutting cycles in history, expecting the fed funds rate to reach 3% by the second half of 2025. This expectation led to a significant drop in long-term yields, indicating a recessionary outlook.
The Fed's decision to cut rates by 50 basis points, which had only a 50% probability of occurring, was intended to address concerns that the Fed was moving too slowly and risking a recession. However, following the rate cut, positive economic data in September and October led to an unusual outcome: while the fed funds rate decreased, nearly every other maturity on the yield curve increased. This resulted in higher borrowing costs across the economy, particularly for long-term loans.
Most borrowing occurs at the long end of the yield curve rather than through short-term money market rates. Consequently, when long-term borrowing costs rise, financial conditions tighten. The recent increase in long bond yields since the 50 basis point cut has led to tighter financial conditions. Term premia have increased, reflecting a higher opportunity cost for borrowing over longer durations. Additionally, 30-year mortgage rates have risen since the rate cut, contrary to the expectation that lower rates would lead to reduced mortgage rates. This rise in mortgage rates caused a brief surge in mortgage refinancing, which has since declined as the opportunity cost of refinancing has become less attractive.
In summary, despite the Fed's rate cut, aggregate borrowing costs have increased due to higher long-term yields. It is essential to consider the broader economy and not just the overnight rate when assessing financial conditions.
