Fed funds vs 10y yields
Fed funds vs 10y yields

This is a chart the Federal Reserve and market participants are thinking about right now.

In the past, 10-year rates roughly matched Fed funds but this time there's a 120 basis point gap. What that means is that hiking to 5.25-5.50% isn't as restrictive as it was in the past.

Some of that gap is being closed with rates rising but much of the thinking around the Fed is about the front end, while a great deal of real-world borrowing is benchmarked from the long end.

The interplay between the short-and-long end is inconsistent and is partly explained by inflation expectations but also by the term premium and deficit worries. Importantly, it may be distorted by QE in the recent era as the Fed still holds a huge chunk of outstanding Treasury debt.

"Somewhat obvious now that CB buying during the QE era had suppressed duration risk. This slow 'unwind feels like a catch-up trade as one by one we regain sanity," writes US government bond trader Ed Bradford today.

The Fed is thinking about this as well and the rise in 10-year rates was something that Minneapolis Fed President Neel Kashkari wrote about earlier this week.

I hate to draw conclusions about a one-way move in bonds into quarter-end like we've just seen but anyone in markets needs to at least consider that the QE regime of 2007-2022 artificially suppressed long-end yields. That may be coming to an end. What's particularly worrisome is that the Fed is still holding massive amounts of bonds and those will slowly leak into the market. Given higher debt levels relative to GDP and a falling appetite for sovereigns to hold US debt, the cost of US debt may (should?) be higher than in the pre-QE era, which should make us contemplate what a world with 7% long-end rates would look like.