The Federal Reserve’s planned interest rate cut on Thursday is facing a formidable headwind in the form of rising U.S. Treasury yields and a strengthening dollar, both fueled by the return of Donald Trump to the White House. While the Fed is expected to lower its benchmark rate by 25 basis points, bringing it to a range of 4.5%-4.75% (its lowest since February 2023), the bond market seems less influenced by the Fed’s dovish stance and more by the fiscal and inflationary implications of Trump’s victory in the 2024 presidential election.
Trump’s Fiscal Plans Drive Deficit Concerns
Trump’s proposed fiscal policies, including his plans for increased spending and tax cuts, are poised to significantly increase the U.S. national debt. The Committee for a Responsible Federal Budget (CRFB) estimates that these policies could boost the federal deficit by roughly $7.75 trillion between 2026 and 2035, driving the debt-to-GDP ratio from 102% to a staggering 143%. In a high-deficit scenario, the CRFB projects a deficit surge of $15.55 trillion, pushing the debt-to-GDP ratio to 157%. This dramatic rise in the national debt would necessitate a significant increase in Treasury issuance, putting upward pressure on yields as investors demand higher returns to compensate for the heightened risks of fiscal instability.
Inflation Concerns Rise with Trump’s Tariffs
Adding to the inflationary concerns is Trump’s pledge to raise import tariffs, including a 60% increase on goods from China and a 10% hike on imports from other countries. Economists widely view these tariffs as an inflationary move, as they would increase costs for businesses and consumers. In response, Treasury yields have climbed sharply over the past two months, with the 10-year yield rising from 3.6% to 4.35%, resulting in a over 5% decline in the U.S. 10 Year Treasury Note ETF (UTEN) since its September highs.
Rising Yields Complicate Fed’s Easing Path
The Fed’s recent rate cuts, including a 50 basis point reduction in September and guidance towards a further cut in November, were intended to lower borrowing costs and ease financial conditions. However, the bond market’s reaction has been the opposite, creating tighter financial conditions despite the Fed’s easing bias. Glen Smith, chief investment officer at GDS Wealth Management, attributed the rising yields to the economy’s strength and expectations for continued government spending and widening deficits. He sees the recent spike in yields as undermining the Fed’s efforts to loosen policy, as bond yields influence the interest rates consumers pay on mortgages and credit cards.
Smith suggested that Thursday’s expected rate cut might be the last for a while, as the Fed could pause its rate cuts in December and into 2025 if the economy remains resilient and disinflation slows.
Inflation Expectations Surge with Trump’s Victory
Trump’s return to the White House has also heightened inflationary concerns. The five-year breakeven inflation rate, a key gauge of inflation expectations derived from Treasury yields, surged 14 basis points to 2.46% on Wednesday, indicating that investors now anticipate inflation to average 2.5% over the next five years. This is well above the Fed’s 2% target.
Russell Shor, senior market specialist at Jefferies-owned trading platform Tradu, expressed concern that Trump’s policies could push inflation even higher. He believes the Fed may feel pressure to tighten its stance on inflation in response to Trump’s tariff and immigration plans, which could drive up prices.
The current situation presents a significant challenge for the Fed as it seeks to navigate the complex interplay of inflation, fiscal policy, and economic growth. The Fed’s ability to maintain control over interest rates and inflation will be heavily influenced by the actions of the Trump administration and the market’s reaction to his policies. The coming months will be crucial in determining the Fed’s course and the overall direction of the economy.
