Monetary Policy Mythology

It’s a myth that the Fed can control the ten-year yield. Investors should take note

When my youngest child was little, he loved reading Greek and Roman mythology. I would read to him about different fabulous creatures, from minotaurs to centaurs, harpies to sirens. It was a lot to keep track of, and quite scary, so I tried to steer him in the direction of less frightening fare.

Personally, I liked contemporary mythology, since I thought it would be less disturbing to hear about alleged sightings of the Loch Ness Monster (and its American cousin, Champy of Lake Champlain), the Yeti (aka the Abominable Snowman) and Big Foot (aka Sasquatch). After all, there have been no reports that any of these creatures have hurt people – and there’s something cute about a giant furry camera-shy man-creature wandering in the woods (made even more lovable by the 1980s movie “Harry and the Hendersons”). An even less intimidating example is the jackelope; essentially a jackrabbit (or hare) with antelope horns on its head.

Investor folklore

There are myths on Wall Street too, although they are not nearly as colorful as those I just mentioned. One is “sell in May and go away” – which was definitely not true this year, as we have seen the S&P 500 make substantial gains since June. Another is that gold is the best inflation hedge; that has not always been the case. There have been times historically when gold has not proven to be a good hedge against inflation – for example, the period 1980–2000. Inflation spiked in the early 80s and 90s and was above 3% for 14 of the 20 years, yet gold’s price actually fell from the 1980 peak to the late-1990s trough. An investor who bought gold in 1980 saw a substantial loss of purchasing power over the next two decades – gold emphatically failed to keep up with inflation, let alone provide a positive real return.

Yields with a mind of their own

The moral of a different Wall Street fable – and perhaps the most important one to be talking about right now – is that if the Fed cuts interest rates, then rates on the long end will come down. That is not always the case. Consider the following examples:

• Back in the fall of 1998, the Fed cut rates by 75 basis points, starting on September 29, 1998. While the 10-year Treasury yield initially fell, it then rose rapidly, from about 4.2% in early January 1999

• On January 3, 2001, the Fed began to cut rates dramatically over a 3-year easing cycle. Rates on the long end initially fell, only to rise again substantially. The 10-year Treasury yield rose from about 4.2% in early November 2001 to 5.4% by April 2022, only to ease and then rise again during this period

• In 2007, the Fed began a rate-cutting cycle that lasted more than a year. From September 2007 to December 2008, the Fed cut rates about 475 basis points However, the 10-year Treasury yield rose from 3.3% in mid-March 2008 to about 4.3% in mid-June 2008

• From July until October 2019, the Fed cut rates three times. While the 10-year Treasury yield initially moved lower, in August it began moving higher – from about 1.45% in August to about 1.9% by the end of the year

• In March 2020, the Fed cut rates by 150 basis points. However, after initially falling, the 10-year Treasury yield substantially from 0.7% at the end of March to more than 1% by early January 2021

• In September 2024, the Fed began cutting rates. By the end of 2024, it had cut rates by 100 basis points while the 10-year Treasury yield rose from 3.6% in mid-September to 4.47% by mid-November of 2024, although it then eased somewhat by year end

The reality is that the 10-year Treasury yield is as unpredictable and difficult to forecast based solely on Fed policy. So I would caution against making any assumptions about where the 10-year yield goes based on what the Fed does. I fully expect the Fed to cut rates in September and at least once more in 2025, but that is pretty irrelevant since I don’t expect the yield to necessarily fall along with the Fed Funds Rate.

Creaking under debt

In recent history, when the Fed has cut and longer dated Treasury yields have risen, there are multiple explanations: some positive, some less so. On the positive side, it can be because markets assume that current policies will drive growth higher. That could be the case this time, as there seems to be a lot of enthusiasm around the pro-growth elements of the One Big Beautiful Bill Act (just look at the most recent NFIB Small Business Optimism Index, where sentiment improved modestly on optimism around the impact of the 20% small-business deduction being made permanent). However, I think it is unlikely given the many headwinds facing the US economy.

Another explanation for Treasury yields on the long end rising despite the Fed cutting is because markets expect inflation to rise. In the 2001-2002 rate-cutting cycle, rising inflation expectations helped contribute to upward pressure on longer-term yields. And then again in the summer of 2008, inflation concerns rose as oil prices moved higher, helping to exert upward pressure on yields. This could easily happen again, given the inflationary pressures we are starting to see, from July’s core Consumer Price Index (CPI) at 3.1% year-on-year and July’s Producer Price Index (PPI) much higher than expected. I think this is more probable, given immigration and tariff policies are likely to only exacerbate inflationary pressures going forward.

Another less rosy reason is that markets judge that the US debt burden is unsustainable. I think this is also a possible scenario: bond vigilantes helping to drive up yields in response to increasing debt. It is worth noting that the US reached another unpleasant milestone last week. As of August 15, the total US national debt is approximately $37.09 trillion. At some point, I would expect bond vigilantes to come out in force and drive yields up sustainably, but we will have to wait and see when.

We should also bear in mind the last time there was overt political pressure on the Fed to lower rates, as it is a cautionary tale. When President Nixon encouraged Arthur Burns to cut rates in the early 70s, the 10-year yield initially tracked rates quite closely. However, this low-rate environment laid the foundations for the inflation/stagflation environment of the mid-to-late 1970s.

I am very confident about the Fed cutting at least twice this year because I believe US economic growth is deteriorating, and that will be the Fed’s priority. Recent canaries in the coalmine include:

• According to the American Bankruptcy Institute, US bankruptcy filings increased 15% from June 2024. However, the bankruptcy increases are coming from individuals rather than corporations. Business bankruptcy filings are on the decline while individual bankruptcy filings have risen 16%

• Farm equipment manufacturing John Deere lowered its full year earnings outlook as lower grain prices are negatively impacting farmers, who in turn have lowered spending

• Fashion brand Tapestry shared that it was being hurt by tariff costs and weakness in one of its brands

• Brewing company Carlsberg reported a drop in volumes and warned that consumers were continuing to pull back on spending

• Klarna, the 'buy now, pay later' fintech company said that it had to set aside more money for potentially troubled loans in the second quarter

Stalling growth plus inflationary pressure from tariffs and tax cuts mean the 1970s precedent should be front-of-mind as we look to the end of the year and beyond.

The US economy isn’t the only place where I am finding ailing canaries. Eurozone ZEW economic sentiment fell by 11 points from July to August, ending at 25.1 – which was below market estimates of 28.1. Drilling down, the German ZEW Indicator of Economic Sentiment decreased for the first time in four months, dropping from 52.7 in July to 34.7 in August 2025. It seems the root of the problem causing weakened sentiment is the EU-US trade deal, which is not viewed favorably by Europeans. That is completely understandable, although I think this will only be a temporary phenomenon given rising fiscal stimulus as countries, especially Germany, increase spending on defense and infrastructure.

Don’t believe the fairytales

Looking ahead, I will be watching the consumer-related companies that are reporting earnings this week very closely. The consumer is becoming more fragile and would be at the epicenter of the economic downturn in the US in my opinion. So it is important to pay attention to what these companies are saying about the health of their consumers.

Jackson Hole also starts at the end of this week. This will be Chair Powell’s opportunity to communicate his current views on the state of the economy, given recent data releases that may have changed his opinion on the balance of risks. This will be his opportunity to signal any change in monetary policy the Fed plans, such as the start of an easing cycle. He may also use it as an opportunity to re-state the importance of an independent central bank. Stay tuned, as this is ‘must see TV’ for Fed watchers.

And, in the final analysis, is there ever smoke without fire? I was stunned to read last week about the presence of ‘zombie rabbits’ in Colorado. Apparently, they suffer from a virus that causes facial mutations which can make them look like they have horns growing from their heads and mouths. So perhaps the jackelope isn’t a myth after all. That said, I think there are some myths — of the Wall Street variety — out there that we must be careful not to believe in.

The Week Ahead

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