WSJ Nick Timiraos - Officials are signaling that a run-up in long-term interest rates might substitute for more hikes.

Edit: Nick Timiraos is known by some on Wall Street as the "Fed Whisperer" and has at times been leaked key shifts in policy thinking at the Fed. Here is a recent article during the quiet week at the Fed leading up to September FOMC.

• A sustained rise in long-term Treasury yields could be bringing the Federal Reserve’s historic rate hiking cycle to an anticlimactic end.

• Top central bank officials have signaled in recent days that they could be done raising short-term interest rates if long-term rates remain near their recent highs and inflation continues to cool.

• Officials initially chalked up the increase in long-term rates to better economic news. But rise in rates increasingly appears to be driven by factors that can’t be as easily explained by the economic or Fed policy outlook, with rising government deficits a prime suspect.

https://www.wsj.com/economy/central-banking/higher-bond-yields-likely-to-extend-fed-rate-pause-53aa56fc

The Fed in July raised its benchmark federal-funds rate to a range between 5.25% and 5.5%, a 22-year high. Officials held rates steady at their meeting last month and indicated they were on track to lift rates at one of their last two meetings this year.

The rise in long-term Treasury yields started after July’s Fed rate increase and gained steam after the September Fed meeting.

The 10-year Treasury yield closed at 4.654% on Tuesday, down from 4.783% on Friday, as investors sought the safety of bonds following Saturday’s attack on Israel by Hamas. Still, yields are up from 4.346% on Sept. 20, the day of the Fed’s last meeting, and 3.850% on July 26, the day of the last Fed rate increase.

The Fed raises rates to combat inflation by slowing economic activity, and the main transmission mechanism is through financial markets. Higher borrowing costs lead to weaker investment and spending, a dynamic that is reinforced when higher rates also weigh on stocks and other asset prices.

The upshot: If the run-up in the 10-year Treasury yields to their highest levels since 2007 persists, those increases could substitute for additional rises in the fed-funds rate.

Officials initially chalked up the increase in long-term rates to better economic news. That prompted bond investors to reduce bets that a recession would prompt the Fed to lower interest rates in the first half of next year.

But the rise in rates increasingly appears to be driven by factors that can’t be as easily explained by the economic or Fed policy outlook, with rising government deficits a prime suspect. This suggests the so-called term premium—or extra yield that investors demand for investment in longer-dated assets—is rising.

“If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed-funds rate,” Dallas Fed President Lorie Logan, a voting member of the Fed’s rate-setting committee, said on Monday. Logan’s remarks were a notable shift from a Fed official who has been a leading advocate for higher rates this year.

Term premiums are difficult to measure precisely. Logan outlined three different approaches and concluded that, across all three measures, at least half of the increase in long-dated Treasury yields since the end of July reflects higher term premiums.

Fed Vice Chair Philip Jefferson, a member of Fed Chair Jerome Powell’s leadership team, similarly indicated on Monday that officials would “remain cognizant of the tightening in financial conditions through higher bond yields” when determining whether to raise rates again this year.

San Francisco Fed President Mary Daly last week said the increase in Treasury yields since Fed officials’ last meeting is roughly equivalent to a quarter-percentage point rate increase in the Fed’s short-term rate. “If financial conditions, which have tightened considerably in the past 90 days, remain tight, the need for us to take further action is diminished,” she said.

Together, their comments suggest the Fed is on course to hold rates steady at their Oct. 31-Nov. 1 meeting. Then Fed officials could wait to see how economic and financial developments unfold next month before deciding whether to raise rates in December.

Even if the Fed is done, officials are unlikely to formally announce any halt in rate rises. They have been repeatedly surprised by the resilience of the economy and would prefer to keep the door open to additional rate rises.

By December, officials would be able to see whether the recent tightening in financial conditions had been sustained and if recent progress on inflation continues. Some officials might be less fearful that robust economic activity, such as surprisingly strong hiring, could stall recent declines in inflation if higher longer-term rates are sustained.

Fed officials had reason to be frustrated last year by how aggressive interest-rate increases only pushed up longer-dated yields modestly, said Brij Khurana, fixed-income portfolio manager at Boston-based Wellington Management. That was in part because investors anticipated the hikes would cause a recession and lead to rate cuts.

As a result, “financial conditions didn’t tighten as much as would be implied by their models,” Khurana said.

Asset managers say the rise in term premiums in recent weeks has been driven by investors grappling with higher-than-anticipated government-debt issuance to finance larger U.S. deficits. A shift now toward higher term premiums would mark an abrupt reversal following the low-inflation, low-growth environment that prevailed between the 2008-09 financial crisis and the pandemic.

Higher term premiums could weigh on investment, spending and hiring if they push down prices of stocks and other assets. “Asset prices thus far have stayed really, really elevated,” Khurana said. “If we have more of a term-premium ‘normalization,’ you could see a world where asset prices move down and owners of assets suddenly are not as willing to spend as they had been in the last year.”