It seems that the Federal Reserve may be changing its stance, although not in the most elegant or refined way. Despite recent employment and inflation data pointing towards a potential increase in the federal-funds rate in November or December, Fed officials have actively downplayed the likelihood of another hike. Surprisingly, this is partially due to the bond market already doing the job for them.

The relationship between bond yields and stock prices has proven itself once again this past week. After a consistent rise in yields since late summer, reaching nearly 5% on the 10-year U.S. Treasury note, and resulting in several consecutive weeks of losses for major stock indexes, yields have now reversed course and stocks have rebounded.

Ending the week on a positive note, the S&P 500 index saw a 0.45% increase, the Dow Jones Industrial Average grew by 0.79%, while the Nasdaq Composite experienced a slight dip of 0.18%. Concurrently, the 10-year yield dropped by 0.16 points, settling at 4.63%.

The catalyst for this unexpected trend reversal was a series of statements from Fed speakers who acknowledged that the surge in bond yields had created tighter financial conditions. As a result, borrowing costs for businesses, consumers, and the U.S. government have increased.

It seems that despite the incongruity with recent economic indicators, the bond market's impact has persuaded the Fed to take a more cautious approach to further rate hikes. While this may not be the most graceful course correction, it appears to be working for now.

The Fed's Stance on Interest Rates

Fed officials emphasize the importance of monitoring financial conditions as they deliberate on future policy.

Fed Vice Chair Philip Jefferson and Dallas Fed President Lorie Logan recently acknowledged the tightening in financial conditions due to higher bond yields. Jefferson stated that he would consider this factor while evaluating the future direction of policy. Similarly, Logan expressed a similar sentiment in separate remarks.

On the following day, Atlanta Fed President Raphael Bostic made his position clear, stating that he does not believe there is a need for further interest rate increases. This unequivocal stance by Bostic leaves no room for interpretation.

This approach seems logical. The prevailing thought is that higher bond yields will slow down the economy and mitigate inflation. Consequently, if the inflation rate declines, the real, or inflation-adjusted, fed-funds rate will effectively rise even without any action from the Fed.

Tom Porcelli, chief U.S. economist at PGIM Fixed Income, observes that Fed officials are deliberately communicating their current stance: they are finished, at least for now.

Interestingly, the market seems to be aligning with this perspective as well. The pricing of interest-rate futures currently indicates less than a one-in-three probability of an additional fed-funds rate increase this year, according to the CME FedWatch Tool. This is a notable shift from the roughly 50/50 odds that were projected a few weeks ago. However, it doesn't imply an immediate decrease, even though the market is already factoring in cuts of 0.75 percentage point next year. Porcelli highlights that the concept of interest rates remaining elevated for an extended period is gaining traction.

Ultimately, this might be the best course of action. If the Fed were to implement faster rate cuts than currently expected in 2024, it would require a more adverse economic outcome that could negatively impact earnings and the stock market.

The Bond Market's Impact on the Federal Reserve

It is important for the Federal Reserve to be aware of the tightening effect in the bond market. While it may not indicate a complete resolution, a Fed that acknowledges this impact is preferable to one that doesn't. This awareness raises the possibility of a potential soft landing for the market.