Unsurprisingly, the U.S. Federal Reserve made no changes in rates in its recent meeting ruling out the possibility of a rate hike in the coming months. Yet, Federal Reserve Chair Jerome Powell has indicated the possibility of prolonging higher interest rates in the face of stubborn inflation. New York Federal Reserve Bank President John Williams reaffirmed on Friday that the Fed's 2% target for inflation is key to achieving price stability and essential for ensuring economic prosperity.
Interest rates have been a historically effective measure for reining in inflation. Nonetheless, their impact appears to have lessened in recent times. Figures from the Federal Housing Finance Agency reveal that from 1998 to 2020, nearly 40% of home loans were 1% less than the consistent market interest rate. By contrast, in late 2023, approximately 70% of mortgage lenders were locked into rates 3% less than the prevailing market rate. This suggests a sustained pattern of higher rates might not produce the immediate disinflationary effect desired by the central bank.
Fed policymakers are planning a comprehensive review of the central bank's policy framework later this year, and several critics are calling for significant changes. Former U.S. Treasury Secretary Lawrence Summers said the Fed should drop its 2% inflation goal. Keeping it, he predicted, would force the U.S. economy into a "fairly serious recession" in the coming years.
That said, an interesting point was highlighted by Jerome Powell. The Federal Reserve will ease back on balance sheet tightening. It had been allowing up to $95 billion a month in proceeds from maturing Treasuries and mortgage-backed securities to roll off each month. Under the new plan, the Fed will reduce the monthly cap on Treasuries to $25 billion. It's a first step to ease potential strain on interest rates. Notwithstanding the banking crisis of March 2023, the central bank's balance sheet decreased by $1.1 trillion over the past 16 months and $350 billion from January to April 2024.
Treasury yields fell on the news. The U.S. 10-year Treasury yield lost 16 basis points over the week to 4.50% from 4.66%, putting an end to a month of almost continuous rise. The yield on the 2-year government bond fell from the 5% mark to drop back to 4.81%.
Treasury yields interacted in Europe even though the European economy is diverging from the U.S., which shows again the leading role of the American market. The 10-year Bund yield dropped 8 basis points to 2.58% from 2.50%. Same move for the 10-year OAT yield sliding from 3.07% to 2.99%.
Against this backdrop, investment grade corporate bonds made up some of their lost ground last month, up 0.46% for the week in Europe (-0.44% year-to-date) and up 0.58% in the U.S. (-2.48% year-to-date). High yield bonds edged up 0.22% in Europe (+1.03% year-to-date) and gained 1.15% in the U.S. bringing their YTD performance to +1.25%. With a weekly rebound of 0.78%, emerging debt in local currency reduced its loss since the start of the year to 3.43%.