NEW YORK — With U.S. inflation easing somewhat and economic growth coming in stronger than expected, expectations are building that the Federal Reserve will leave its benchmark rate unchanged at the Federal Open Market Committee meeting on Oct. 27-28. Market Treasury yields, meanwhile, have climbed separately to their highest levels of the 2000s, led by long-dated maturities. Supply remains heavy because of the federal government's large budget deficit, and hyperscalers — operators of ultra-large data centers — have not stopped issuing corporate bonds to fund artificial intelligence infrastructure. Instability in the Middle East, which has kept crude oil near $100 a barrel, and a real economy that is proving stronger than expected are also pushing market yields higher. Some in the market nonetheless read the current rise in yields as reflecting expectations of long-term productivity gains from the adoption of AI. Leaving open the possibility that the 30-year yield, the benchmark for U.S. mortgages, could rise to 6%, some argue that the trend will not necessarily be bad news for the global economy up to a point. Indeed, the New York stock market has not come under heavy pressure despite the high-flying Treasury yields. There are, of course, plenty of voices on Wall Street arguing the opposite. If yields keep rising, interest costs will climb for indebted Big Tech companies and households, which could dampen investment and consumption over the long run. How soon companies investing in and adopting AI can demonstrate improved productivity and profitability will likely determine which reading of the current yield trend prevails.
August PCE Price Index Rises 3.4%, Below Forecast; Q2 GDP Grows 2.2%, Beating Expectations
The Commerce Department said on the 30th that the personal consumption expenditures price index rose 3.4% in August from a year earlier. That was below the 3.7% expected by economists polled by Dow Jones. It rose 0.3% from July, matching forecasts. The core PCE price index, which excludes energy and food, rose 3.0% from August last year and 0.2% from the previous month. Dow Jones' consensus forecasts for core PCE were higher, at 3.3% and 0.3%.
The increases remain well above the Fed's 2% target but came in far below what the market had feared. The PCE price index is the inflation gauge the Fed weighs most heavily in setting its benchmark rate.
The reading also drew attention as the first compiled since the Commerce Department overhauled the index's composition. As a result of the revision, the July PCE price index's year-on-year increase was lowered to 3.4% from 3.7%. Core PCE was revised down to 3.0% from 3.3%.
According to The Wall Street Journal and other outlets, the Commerce Department's Bureau of Economic Analysis revised the methodology used to calculate three subindexes: portfolio management services, software and legal services. The changes were applied retroactively to data from the past five years.
For software, the bureau added price data on video game software and web hosting — the cost of renting internet servers — compiled by the Bureau of Labor Statistics under the Labor Department. For portfolio management services, it replaced the current method of totaling fees paid by individuals with a more complex approach that compares the revenue financial firms earn against their workload. Management fees generally rise as stock prices climb, and the change reflects criticism that such increases should not be counted as inflation. For legal services, the bureau switched to the producer price index from the consumer price index it had been using, after the Bureau of Labor Statistics decided to stop publishing the figure because of data collection problems.
With inflation relatively contained, U.S. economic growth proved very solid. The Commerce Department said the final reading for second-quarter gross domestic product growth came in at 2.2% on an annualized quarter-on-quarter basis. That was 0.7 percentage points higher than the preliminary 1.5% reported on Aug. 26, and above the market forecast of 1.5%. Notably, final sales to private domestic purchasers — the sum of PCE and private fixed investment — rose 4.6%, accelerating from 1.8% in the first quarter. The measure is a key gauge of spending and investment sentiment in the U.S. private sector.
U.S. GDP growth is calculated on an annualized basis, the rate that would result if the current pace of growth were maintained for a full year, measured against the immediately preceding quarter. That differs from the method used in South Korea and elsewhere, where GDP is compared with the same period a year earlier.
Odds of an October Hold Rise to 63% From 49%; 30-Year Treasury Yield Tops 5.6% for First Time in 24 Years
Data released the same day also showed U.S. employment holding up relatively well. Private-sector payrolls rose by 90,000 in September from August, according to private payroll processor Automatic Data Processing. That was well above the 68,000 expected by economists polled by Dow Jones. August's gain was revised down to 36,000 from 38,000. By sector, education and health services added 55,000 jobs, accounting for about 61% of the total increase. Wage growth also continued, with total pay up 4.4% from a year earlier for workers who stayed in their jobs and 7.3% for those who changed employers. The Labor Department's September nonfarm payrolls report is due on the 2nd. The market expects nonfarm employment rose by 84,000 last month, with the unemployment rate holding at 4.1%.
The run of reports showing the U.S. economy in fairly good shape further boosted expectations for a rate hold. According to CME's FedWatch, the federal funds futures market on the same day raised the probability that the Fed will leave rates unchanged at the October FOMC meeting to 62.9% from 49.4% a day earlier. The probability of a 0.25 percentage point increase fell to 37.1% from 50.9%. The odds that the Fed will raise rates just once by 0.25 percentage point this year also rose to 58.0% from 49.4%, while the chance of two increases fell to 30.0% from 42.2%. At its meeting on the 15th and 16th, the Fed raised its benchmark rate by 0.25 percentage point to 3.75%-4.00%, the first increase in three years and two months, since July 2023.
On that front, New York Federal Reserve President John Williams, seen within the Fed as a dove favoring easier policy, said in a speech at the University at Buffalo in New York state on the 29th that "if the economy evolves broadly in line with my forecast, it may be appropriate to adjust the target range for the federal funds rate up once more later this year so that inflation returns to the target in a timely manner." He added that "the policy action taken at the September meeting means there is no need to rush, and there is time to gather more information," and said that "tariffs are no longer contributing to goods inflation, but the inflationary effects of an AI-related demand shock are becoming increasingly evident." The New York Fed president is the only regional Fed chief who holds a permanent seat on the FOMC and serves as its vice chair.
Even as the odds of an October increase receded, the climb in bond yields did not stop. The 10-year Treasury yield, the benchmark for global bond markets, rose as high as 5.306% during the session, the highest since May 2002. That exceeded even the 5.303% reached in 2007 during the global financial crisis. The 30-year Treasury yield rose to 5.652% intraday and the policy-sensitive two-year yield to 4.899%. As Treasury yields surged, the Dow Jones Industrial Average (-0.86%), the Standard & Poor's 500 (-0.25%) and the Nasdaq Composite (0.24%) — all of which had opened higher on hopes for stable inflation — ended mixed.
Deficits, AI Investment and Iran War Stalemate Lock Yields in the 5% Range as Housing and Consumption Wobble
U.S. Treasury yields, both short- and long-dated, appear to be settling well above psychological resistance levels in the 5% range. The shift reflects the combined effect of Treasury supply from a federal government seeking to roll over a massive deficit through debt and corporate bond issuance by hyperscalers looking to fund astronomical AI infrastructure investment with borrowed money. In July, global investment bank Morgan Stanley forecast that AI-related corporate bond issuance would more than double from last year to $570 billion, or about 770 trillion won, this year.
Adding to the picture, oil prices have remained unsettled as negotiations over the Iran war stall. Critics say even the August PCE price index is inadequate because it does not reflect the record-high diesel prices seen in the U.S. from September. The increase in the August PCE price index was itself led by gasoline prices, which jumped 4.4% from July. Crude is currently trading around $100 a barrel, with passage through the Strait of Hormuz restricted and Yemen's pro-Iran Houthi rebels having taken control of areas up to the Red Sea. On the same day, Brent crude futures for November delivery settled 0.92% higher at $103.53 a barrel on the ICE Futures exchange in London, while West Texas Intermediate futures for November delivery closed 1.16% higher at $90.42 a barrel on the New York Mercantile Exchange.
The surge in Treasury yields lifted the dollar to a 16-month high against the euro and the Swiss franc as of the 29th. According to Reuters, the euro fell as low as $1.1312 in New York trading on the 29th, its weakest since May last year. The Swiss franc also slipped 0.17% to 0.834 per dollar, a 16-month low. The dollar index, which tracks the greenback against six major currencies, rose to 101.45 on the 30th, the highest since 101.61 on June 24.
The average rate on a 30-year fixed mortgage in the U.S. rose for a fifth straight week to top 7%. According to Freddie Mac, the government-sponsored mortgage company, the average 30-year fixed mortgage rate stood at 7.03% as of the 24th, up 0.08 percentage point from 6.95% the previous week and 0.73 percentage points above 6.30% a year earlier. The actual average contract rate for the third week of September, compiled by the Mortgage Bankers Association on the 23rd, came in at 7.12%, breaking above 7% for the first time since President Donald Trump returned to office in January last year. As recently as Feb. 27, just before the outbreak of the Iran war, the average U.S. mortgage rate was only 5.98%.
Consumer sentiment is also showing strain. The Conference Board, a U.S. business research group, said on the 29th that its consumer confidence index fell 6.7 points to 81.9 in September (1985=100) from 88.6 in August. That was well below the 89.0 expected by economists polled by Dow Jones and the lowest level since April 2014. The present situation index, which reflects current business and labor market conditions, fell 7.9 points from August to 109.3. The expectations index, which reflects the short-term outlook, fell 5.9 points to 63.6, extending its decline to a third straight month.
Wall Street Leaves Door Open to 6% as Optimism and Pessimism Mix, Capping Stock Gains
Interpretations of the surging Treasury yields are divided on Wall Street as well. According to Bloomberg on the 30th, Anshul Pradhan, head of U.S. rates research at Britain's Barclays, wrote in a report that "the market continues to assume that the current elevated level of rates will prove to be cyclical rather than structural," and projected that the 30-year Treasury yield could rise to 6%. A 6% yield on the 30-year note would be the highest since June 2000.
Pradhan said investors also expect the Fed's rate-hiking stance will not last long, and laid out a pessimistic scenario rebutting that view. Citing a "more productive economy," he added that "the outlook for where the policy rate ultimately lands needs to be revised upward, and long-dated yields will move higher accordingly." Rising interest costs would worsen the fiscal outlook, he explained, potentially setting off a vicious cycle of further yield increases. Pradhan said yields would fall in a scenario where the frenzy of expanding AI capital expenditure quiets down and the economy slows.
Market unease about the seemingly brakeless rise in yields is evident in several corners of the market. The clearest sign is that while New York stocks are not falling sharply despite rising Treasury yields, they are not tracing a clear upward curve either. Even with benign inflation data and solid growth figures, the probability of a Fed hold this month has not risen to the level of a foregone conclusion. If anything, the odds of a hold jumped during the session on the 30th before easing somewhat late in the day as the market felt the strain of climbing Treasury yields.
Nor do many Fed officials yet see inflation as tamed. St. Louis Fed President Alberto Musalem struck a hawkish tone favoring tighter policy in a discussion hosted by the Centre for Macroeconomics at the London School of Economics on the 29th, saying monetary policy remains "somewhat accommodative" even after the September increase. Chicago Fed President Austan Goolsbee, speaking at an Official Monetary and Financial Institutions Forum event in London the same day, said that "if very persistent supply shocks begin to emerge, we have to consider responding to them." Fed Governor Michael Barr, in a speech to the Detroit Economic Club in Michigan on the same day, signaled the possibility of further increases, saying he does not "yet see a clear trend of inflation returning to 2% in a timely manner."
With optimism and pessimism crossing over the rise in Treasury yields, New York stocks look unlikely to mount a steep rally for some time. The reason is the considerable room for further increases — enough that some now expect the 30-year Treasury yield to break above 6% for what would effectively be the first time this century.
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