The Big Picture

Interest rates are higher these days for a variety of reasons. Some think they are too high for the good of the economy. Others think they are right where they belong because of how good the economy is.

Somewhere in that mix is a tussle over sticky inflation and misgivings about the U.S. fiscal situation.

What is clear in the chart below is that Treasury yields are roughly where they were before the Great Financial Crisis unfolded (i.e., the last time things were "normal").

From QE to QT

As the financial crisis unfolded, the Federal Reserve took extraordinary measures that included lowering the fed funds rate to the zero bound and blowing out its balance sheet with a massive program buying Treasury and agency mortgage-backed securities.

The latter was known as a quantitative easing program, whereby the Federal Reserve purposely worked to suppress market rates with its purchases to stoke loan demand and stronger spending activity. This "QE" program was not normal, yet Ben Bernanke, and then Jerome Powell, embraced this policy tool during their respective crisis management phases.

Nowadays, the Federal Reserve is working to shrink its balance sheet with a quantitative tightening program ("QT").

It has had some success shrinking its balance sheet from roughly $9 trillion in 2022 to "only" $6.8 trillion today. For some normal perspective, however, bear in mind that the Fed's assets were roughly $900 billion when the Great Financial Crisis exploded in 2008.

The Fed is trying to return to normal by shrinking its balance sheet. Ultimately, it looks destined to be stuck in the "new normal" of a bloated balance sheet for some time for several reasons:

1. The U.S. is a deficit-financed growth company that perennially requires the issuance of debt to pay for outlays that aren't fully covered by receipts.
2. The Federal Reserve, under its ample reserves regime, intends to slow and then stop the decline in its balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves¹. At his most recent press conference, Fed Chair Powell observed that the most recent data suggest that reserves are still abundant, remaining roughly as high as they were when the runoff began.
3. Improved yields in other sovereign bond markets threaten to reduce the level of purchase activity by foreign buyers.
4. The geopolitical risk China faces by holding dollar-denominated assets, which could be frozen in the event of a hostile action (i.e., invading Taiwan), has presumably tempered some of the buying activity by the Treasury market's second largest foreign buyer (behind Japan).

Fed Takes Normal Stance

Quantitative easing is no longer a theoretical concept. It is now enmeshed as a viable instrument in the Fed's toolbox.

What do you think will happen if the U.S. has an economic crisis that destabilizes the financial system?

There will be rate cuts of course, but if it is a profound crisis that kills consumer demand and investor confidence (as profound crises are wont to do), it is a safe bet that the Fed will go back to the QE well.

Let's hope that it isn't necessary again. It isn't normal.

What is looking closer to normal these days is the level of the fed funds rate. It, too, recently sat at levels (5.25-5.50%) last seen before the start of the financial crisis.

The Fed has implemented 100 basis points of easing since last September, yet Fed Chair Powell said this past week that it is the broad sense of the FOMC that the Fed doesn't need to be in a hurry now to adjust its policy stance. That thinking is tied to the fact that the progress of inflation toward the 2% target has slowed, the labor market has remained solid, and the economy is growing nicely. At the same time, there is heightened uncertainty about what impact President Trump's tariff proposals will have on inflation and the economy.

The Fed is in a wait-and-see mode, which is normal. Raising rates or lowering rates at successive meetings isn't normal. To be sure, a policy rate at the zero bound for years on end isn't anywhere close to normal either.

The Fed, to its credit, has the policy rate back at a level that gives it optionality to cut more if needed, and it got it there without tanking the economy.

Market rates went up with the policy rate and in recognition of an economy that showed signs of acceleration despite the rate hikes. Surprisingly, they also went up after the Fed started to cut rates again in September 2024.

This is where we get back to the tussle over inflation and the U.S. fiscal stance. Fed Chair Powell thinks the move by the 10-yr note is more of a term premium story and not because of expectations about Fed policy or about inflation. Some will debate that view, but implicit in it is a belief that worries about the deficit are the main driver.

We won't expound on the deficit situation here other than to say that it isn't normal that the budget deficit as a percentage of GDP is as high as it is with an economy as strong as the economy we have now. Treasury market participants, we suppose, are wrestling with the idea of how much worse it could get if there is an economic downturn or growth from deficit-financed tax cuts doesn't materialize as advertised; hence, the increase in the term premium.

There is a lot of energy right now behind the idea of the Trump administration cutting the cost of government (without touching Social Security, Medicare, or Medicaid). The feasibility of that effort is in question, though, with Congress controlling the purse strings and politicians needing to deliver on the special interests of their respective constituencies at the risk of losing their job if they don't.

In the past, talking about cutting the deficit was cheap. We'll see if that remains the case. It is too early to tell, but there has certainly been a lot of talk about cutting the deficit and getting the U.S. back on a sustainable fiscal track. Wouldn't that be a nice return to normal?

What It All Means

It hasn't been easy seeing market rates return to normal levels. Any prospective homeowner will tell you that, as would any homeowner hoping to move but not wanting to give up what we might say is an abnormally low mortgage rate.

Savers and investors, though, have had a lot to cheer watching market rates move higher. Now, they have options to get some real return on Treasury securities, certificates of deposit, high-yield savings accounts, and money market funds that carry less risk.

Investors can strike a better balance in their investment portfolios, which per chance got too overweight with stocks when real returns on savings accounts and Treasuries, for instance, were negative.

There is a real option again to diversify. In other words, there is an alternative to stocks should one choose to go down that road.

One of the best things we saw during the DeepSeek selloff was the safe-haven buying interest in the Treasury market.

That was a normal reaction, and participants didn't have to accept abnormally low yields for going there. Market rates were at normal levels. It has been a long, tough road getting them back there, and it may just be the best return of all to normal for investors, assuming inflation and the deficit can be successfully redirected to a normal path.

--Patrick J. O'Hare, Briefing.com

¹Zobel, Patricia. (2022, September). The Ample Reserves Framework and Balance Sheet Reduction: Perspective from the Open Market Desk. Federal Reserve Bank of New York.