Fed's Emergency Rate Cut Backfires as Treasury Yields Surge, Election Looms
When the Federal Reserve decided to cut interest rates by an emergency 50 basis points on September 18, all the while claiming that the U.S. economy was still "good," I couldn't help but question their decision-making process. Just over a month later, both the 2-year and 10-year U.S. Treasury yields surged by about 50 basis points, reaching 4.02% and 4.18%, respectively. On top of that, there's chatter in the markets suggesting that the 10-year yield could even test 5%. How did the Fed not anticipate this?
If their economists foresaw this kind of rise in yields, why did the Fed cut rates when their stated goal seemed to be keeping yields lower? And if they didn't anticipate this, it raises another concern: does the Fed truly know what it's doing? On one hand, Fed officials like Mary Daly continue to push for further rate cuts to guard against a weakening labor market, despite no clear signs in the latest data of significant labor market stress. Yet other voices within the Fed, at least, are calling for more moderate steps, like 25 basis point cuts. That might help prevent yields from rising too sharply, but even Neel Kashkari is now questioning whether the neutral rate for the U.S. might need to be higher.
Some of the recent spike in yields can be attributed to seasonally adjusted U.S. data, which explains a portion of the move. But we can't ignore the looming U.S. election, which is now just two weeks away. Betting markets, for whatever they're worth, are increasingly backing Trump to win. Could we be seeing trades anticipating higher inflation under a second Trump presidency?
There's no shortage of election drama either. Vanity Fair warns that "We All Have a Lot to Lose If Trump Wins," claiming that a second term could mark the end of democracy as we know it. The Atlantic has compared Trump's rhetoric to that of Hitler, Stalin, and Mussolini, and Rolling Stone went even further, framing Trump's closing pitch to voters as "I Will Let You Die If You Don't Bow to My Demands." While the mainstream media is escalating its rhetoric, the financial markets are fixated on something much more specific: trade and tariffs.
Take Bloomberg, for example. In its typical "non-partisan" style, the financial news giant editorialized that Kamala Harris should challenge Trump on trade and tariffs. But the analysis they presented was deeply flawed. They cited a story about two U.S. towns affected by tariffs on Chinese goods, suggesting this proved tariffs don't work. But the story actually underlined the opposite. It showed how Biden's tariffs on trailers, used for shipping containers, led a Chinese firm to set up production in the U.S., which bolsters the case for tariffs. The rival U.S. firm, meanwhile, was penalized for using Chinese steel routed through Thailand, further supporting the notion that tariffs can reshape global supply chains. The analysis also mentioned how the trailer industry was hit hard by the end of COVID-19 lockdowns and reduced port activity, which had nothing to do with tariffs. Despite this, Bloomberg insisted Harris should distance herself from both Biden's and Trump's trade policies, as though free trade is a winning electoral issue. Perhaps this resonates inside Bloomberg's offices, but it's not likely to strike a chord with Main Street, where people seem more concerned with local jobs than global financial flows.
Now, I'm not saying tariffs can't be inflationary—of course, they can. In fact, that's our base case moving forward. But if this is the level of economic and political analysis we're working with, the authors may want to consider applying for a job at the Fed, where similar missteps seem to be the norm.
Meanwhile, as the market loses focus on the Middle East, the situation there remains tense. Israeli reports suggest that Hezbollah's recent drone strike on Prime Minister Netanyahu's residence will provoke a more severe response against Iran than previously planned. Back in 2012, an Israeli strike on Iran's nuclear program was thwarted when the U.S. leaked logistics to Iran. This time, Israel may be planning retaliatory strikes on Iranian leaders' homes, military facilities, and nuclear sites. Escalation seems inevitable, and if oil gets caught up in the crossfire, markets could face a major shock. In Lebanon, Israel has already struck a Hezbollah-linked bank and released videos suggesting that Hezbollah is hoarding $500 million in cash and gold under a Beirut hospital, effectively inviting the Lebanese public to help themselves. If a similar strategy is deployed against Iran, we could be in for some serious market volatility.
In Europe, we're also seeing tension on the rise. Tiny Moldova, with a GDP per capita of just $6,651, recently voted in a referendum to begin the process of joining the European Union. Only 11,602 votes separated the two sides in this polarized country, which borders the pro-Russian breakaway region of Transnistria. As Moldova moves closer to the EU, expect tensions with Russia to escalate. Branko Milanovic, always insightful, recently noted that small, polarized countries in today's geopolitical climate face a dangerous choice: aligning with either side could lead to civil conflict. Libya and Iraq are cautionary tales in this regard.
On the global stage, while Washington, D.C. is hosting the annual IMF and World Bank meetings amidst war, sluggish economic growth, and the U.S. election, there's also a BRICS summit taking place in Russia. It's the first summit since the BRICS expanded, and though it's received little attention in the West, it's noteworthy. While we won't see an alternative to the U.S. dollar any time soon, there may be progress towards Russia's plan for a BRICS-based grain exchange, which could set price floors and ceilings for the global grains market. Though such a system would likely still be priced in dollars, it hints at the potential for the BRICS to exert more control over key agricultural markets.
If the grain exchange proves successful, it could expand to other commodities where the BRICS have significant resources. But anyone expecting a similar shift in energy markets is probably overestimating things. Instead, they might want to focus more on U.S. bond yields, where the real action seems to be taking place.