Rates and Inflation on the Rise

Last Week in Review: Rates and Inflation on the Rise

The Federal Reserve has been very clear on their communications over the past 18 months. They want to see inflation run hotter before even thinking about raising interest rates. And when we say interest rates, the only interest rates the Fed can control are short-term interest rates, by hiking or cutting the Fed Funds Rate. Long-term rates, like mortgages, are driven by the financial markets and inflation expectations. Yes, the Fed is buying bonds to manipulate long-term rates — more on that below.

If inflation is rising, it puts upward pressure on long-term rates, which is exactly what has happened over the last two weeks as inflation expectations rose to the highest level in two years and the 10-year yield spiked to 1.19%, the highest level since last March.

The Quandary?

More stimulus is on the way. The incoming Biden administration has put forth a plan to spend trillions of dollars to help revive and stimulate the economy, and this is a major reason why inflation expectations, real asset, and commodity prices are rising, thereby causing the spike to be higher in long-term rates.

The incoming huge stimulus and rising inflation expectations would normally give the Fed reason to stop buying bonds every month. Remember, the Fed is currently purchasing at least $120B in Treasurys and mortgage-backed securities (MBS) each month to artificially help keep long-term rates relatively low. So, with inflation rising, does the Fed stop buying bonds and let market conditions dictate the real pricing of interest rates? Not any time soon.

And while some Fed members were out talking about “tapering” purchases, Fed Chair Powell spoke on Thursday and told the markets they will continue the present bond-buying program.

This means we may see a continued uptick in inflation expectations, and the Fed may be pressured to do even more, like buy additional bonds to help keep long-term rates low.

Bottom line: With only a couple weeks into 2021, we are already seeing a shift towards slightly higher rates.