The Yield Curve May Be Telling Us What the Fed Will Do
The Fed is standing still on interest rate moves. The yield curve may be showing what the bond market believes will happen next
So much has shifted with the economy over the past few months, and the seismic shifts move in different directions almost daily.
There are a few things that anyone involved in the markets needs to watch daily:
What will happen with the tariffs?
What is happening with the Big Beautiful Bill?
What is happening abroad that could affect the US economy & markets?
This is a lot, and as I said, everything changes rapidly. Looking at the chart above, the market is putting together its consensus, and we see that consensus playing out in the yield curve. The bond market is the true discounter of the economy. You always want to pay attention to the bond market—they are almost always right.
The Tariffs Are Here… And Now Gone… sort of.
The tariffs are one of the most significant factors to pay attention to. For the United States, the tariffs were a tax on consumers. The purpose of the tariffs was to raise revenue to offset tax cuts in other areas. The idea was that the tariffs could generate approximately $350-$400 billion in tax revenue.
However, two courts have ruled that Trump way overstepped his authority by laying down taxes across the board as he did.
The courts will ultimately strike down the tariffs completely at some point. But, the infamous Big Beautiful Bill is counting on those tariffs. If the budget passes nearly as it is from the House, and the tariffs are removed, that would be a significant issue for the budget and its potential deficit.
My take? The budget passes mostly as is… then the tariffs are permanently removed. Until then, everything is finger-crossing and noise. I am getting ready for this.
The Bond Market Is Getting Ready For This
We have an inverted yield curve, which is signaling to participants several things about future expectations.
The front is elevated somewhat. This is the bond market telling us that it does not believe short-term interest rates will move anytime soon.
Then, there is the middle area, where the bond market is indicating that it believes interest rates will eventually move lower, just not right now.
After that, we see what the bond market thinks in terms of the longer end, indicating that interest rates are expected to rise over a longer period.
We have an inverted yield curve.
Inflation… for now
The latest inflation report indicates that price pressures are easing. The thing to keep in mind about the tariffs and price pressures is that many companies pre-ordered supplies ahead of the tariffs. This will alleviate price pressures. So, price increases would likely be drawn out for a more extended period instead of one big push upward.
Then there is the fact that the tariffs are a uniquely American policy. In the United States, the tariffs will push prices up—tariffs are a tax, and this tax will suppress economic activity as consumption declines.
But while the United States will see economic erosion because of the tariffs, price pressures felt by other countries will actually decrease. The tariffs affect US consumer expenditures. If US consumption declines, price pressures worldwide will also decline due to lower demand.
That may actually offset some price increases from the tariffs.
But then the tariffs go away.
Japan Is Pushing The Markets
The above chart shows the inflation rate in Japan. Price pressures are moving higher, and this is an astounding development coming from a country that has seen negligible economic growth and price pressures.
The Bank of Japan had been buying massive quantities of Japanese Government Bonds (JGBs) over many years to inflate the economy. By turning on the proverbial printing presses and printing as much money as they reasonably could, the idea was that price pressures would increase, and consumers would get busy spending money.
With its bond purchasing program, the Bank of Japan made it impossible for the market to price-discover where Japanese debt instruments should be.
Now, the Bank of Japan is slashing its bond purchasing program.
What will happen to the price of Japanese Government Bonds?
Up would be a very simplistic quantifier.
Bond prices in Japan may plummet, while interest rates soar. The fact that there is increasing inflation will be a contributor to this. Fortunately, price pressures worldwide may see some relief because fo the United States tariffs… but, remember: the tariffs go away.
For now, Japanese bond yields are increasing, and I expect this to continue. While the US 10-year Treasury has certainly outpaced Japan, it may be that this is just the beginning of a bigger move.
Japan may be a sleeping dragon that is being awoken right now. True, there are serious structural issues with a population size that is in decline. But, they have a budget deficit ratio that is ~236% of GDP. While the Bank of Japan has been doing as much as it can to prop up the economy, these moves have distorted the markets. We are about to witness how those distortions will be reoriented in the markets.
What happens then?
Because of the moves in the Japanese bond market, this will directly affect the US bond market.
I see a systematic move upward in US Treasury yields, and mostly this will show up later. This will take time, and it may be that the market is signaling this through the yield curve. The longer end is moving higher. However, the Fed may be able to move interest rates lower in about 6, 9, or 12 months.