Well, it happened. The benchmark 10-year Treasury officially hit 5% late yesterday afternoon. It's become more popular than Tesla and Nvidia on our website lately. That's how focused the investing public is on it. Its upward surge has been so sharp lately as to be considered somewhat "disorderly." 

The awkward conundrum is that it's a financial market problem that may not have a financial market solution. If yields were simply jumping because of better growth prospects or higher inflation, then yes, the Federal Reserve could step in and do something about that. But if yields are becoming untethered because Treasury supply, on the back of higher-than-expected U.S. budget deficits, is dwarfing the appetite of buyers, that's a trickier issue.  

If growth were weak, or we were in a recession, then actually the Fed could step in and become a big buyer of government debt again, like it was last decade. That would certainly all result in lower bond yields. But if the Fed steps in now to buy Treasuries, that would just re-stimulate the economy and push inflation up again. 

In fact, they have been shrinking their balance sheet of government debt to the tune of $1 trillion already, and some argue they need to do a lot more. Jefferies' David Zervos has been warning for months that the Fed's $8 trillion balance sheet of debt holdings is cushioning the blow of rate hikes by keeping the losses "in-house," so to speak,  thus requiring ever more hikes which are battering certain industries, like housing.  

So again, the Fed is trying to get out of the government debt market, not back in. Which brings us back to the problem of surging Treasury yields. Fed Chair Powell gave a speech in New York yesterday in which he acknowledged that "long-term bond yields have been an important driving factor" in tightening U.S. financial conditions lately. But he stopped short of explaining why yields have been surging, or what the Fed could or should do about it.  

In fact, he deflected the issue entirely in the question-and-answer portion after his speech. When asked about the problem of budget deficits, Powell answered, "We don't focus on fiscal policy. We wouldn't change monetary policy because we think, for instance, the U.S. is on an unsustainable path. Everyone knows that. We're just going to focus on maximum employment and stable prices."  

That's because the Fed has a "dual mandate," as it's popularly known, dating back to the Federal Reserve Reform Act of 1977, to focus on maximum employment and stable prices. But in fact, Powell didn't mention the whole story. There is actually a third mandate in that Reform Act; it just rarely gets mentioned, because it hasn't been a key focus of policy debates over the past four-and-a-half decades.  

The legislation as it reads actually requires the Fed to "promote the goals of maximum employment, stable prices, and moderate long-term interest rates." (Emphasis mine.) For most of the past several decades, it was taken for granted that if the Fed achieve its first two goals, the third would take care of itself. But that is being called into question now. 

Right now, we seem to have an economy with with maximum employment, stable prices, and jumping long-term interest rates. You could argue 5% on the 10-year is still "moderate," but it's all relative. The "real" rate, adjusted for inflation, is 2.5%, using the yield on 10-year TIPS as a proxy. If we break above 2.6%, we'll be at two-decade highs. If we go beyond that, we'll fully unwind the "Great Moderation" and be back at 1990s real rates that were coming off the "bad old days" highs from the '70s and '80s.  

All of this is why former Dallas Fed President Robert Kaplan says the Fed needs to start talking more about what's really driving yields higher. And yes, that might mean officials have to call out, in their own cloaked way, fiscal problems. But they do have a mandate to keep long-term interest rates "moderate." It is certainly in their wherewithal to explain how they can--or can't--achieve that goal.  

See you at 1 p.m! 

Kelly 

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