In Part 1, we saw that a bond’s price moves opposite to its yield, that long bonds swing more than short ones, and that yields reflect expected short-term rates, expected inflation and a term premium.
Part 2 asks the next question: where do those expected short-term rates come from? The answer is the Federal Reserve. From there, we can build the yield curve and watch how it changes shape as the economy moves through its cycle.
What is the federal funds rate?
Banks hold reserves at the Federal Reserve, and every day some banks have more than they need while others are short. They lend reserves to each other overnight. The interest rate on those overnight, unsecured loans between banks is the federal funds rate.
It sounds obscure, but it is the anchor for almost every other interest rate in the US economy. When people say “the Fed raised rates”, this is the rate they mean.
How does the Fed set it?
The Fed doesn’t dictate a single number. Its policy committee, the Federal Open Market Committee (FOMC), meets eight times a year and announces a target range for the fed funds rate, such as 4.25%–4.50%.
It keeps the market rate inside that range mainly with two administered rates:
- Interest on reserve balances (IORB): what the Fed pays banks on the reserves they keep at the Fed. No bank will lend reserves to another bank for much less than it can earn risk-free at the Fed, so IORB acts as a guide for the rate.
- The overnight reverse repo (ON RRP) rate: what the Fed pays money market funds and other institutions that can’t earn IORB. It works as a floor for the wider market.
When the FOMC raises its target range, it raises these administered rates, and market overnight rates follow almost immediately.
Why does the Fed move rates?
The Fed has a dual mandate from Congress: maximum employment and stable prices. In practice, “stable prices” means inflation of about 2% a year over time.
- If inflation is running too hot, the Fed raises rates. Borrowing becomes more expensive, spending and investment cool down, and price pressures ease.
- If the economy is weak and unemployment is rising, the Fed cuts rates to make borrowing cheaper and support demand.
Policy works with long lags. Piper Sandler’s “H.O.P.E.” framework, describes the order in which the economy feels a rate hike:
- Housing reacts first, because mortgages are very rate-sensitive.
- Orders come next. New orders in manufacturing slow down (you see this in the ISM).
- Profits weaken, and analysts cut earnings estimates.
- Employment falls last. Only then does inflation really come down.
The full pass-through can take up to two years. That’s why the Fed has to act on forecasts, not just on today’s data.
How does the Fed’s rate reach the rest of the market?
The Fed directly controls only the overnight rate. Everything else is set by the market, mostly through expectations.
- Short-term rates (Treasury bills, money market funds, credit cards, the prime rate) follow the fed funds rate closely.
- Longer-term rates (the 10-year Treasury, 30-year mortgages, corporate bonds) depend on what the market expects the Fed to do over the life of the bond.
A simple way to see this: a 2-year yield is roughly the average of the 1-year rates the market expects over the next two years. If the 1-year rate is 4% today and the market expects 5% a year from now, the 2-year yield should sit around 4.5%, plus a small term premium.
Stretch the same logic out to 10 years:
Long-term yield ≈ average expected short rate over the bond’s life + term premium
The Fed can also influence long rates more directly by buying bonds (quantitative easing, QE), which pushes long yields down, or by letting its bond holdings shrink (quantitative tightening, QT), which tends to push them up.
What happens to long rates when growth is strong?
This was the question I got stuck on, so it deserves its own section.
If strong growth is expected to last, long-term rates go up. Three forces push them higher:
- Real rates rise. Companies want to borrow and invest, so they compete for capital.
- Expected inflation rises. A hot economy with little spare capacity tends to push prices up, and bondholders want to be paid for that.
- The Fed is expected to keep rates high for longer, which lifts the average expected short rate.
This is why the ISM manufacturing index and the 10-year Treasury yield tend to move together: when the ISM rises, yields usually rise too.
But what matters is how long the market expects the strength to last:
- Strong growth expected to last (for example, a productivity boom): long rates rise a lot.
- Strong growth expected to fade (an overheating economy the Fed is about to cool down): long rates rise, but by less than short rates, because the market expects the Fed’s hikes to work and rates to come back down later.
- Growth expected to collapse: long rates can fall even while the Fed still holds short rates high.
The yield curve
The yield curve is a line that plots Treasury yields against their maturities, from 3 months to 30 years. Its shape tells you how the market sees the future.
- Normal (upward sloping): long yields above short yields. Investors expect rates to stay stable or rise, and they earn a term premium for lending longer.
- Flat: long and short yields about the same. The market sees little change ahead, often near a turning point.
- Inverted: short yields above long yields. The market expects the Fed to cut rates in the future, usually because it expects the economy to slow. An inverted curve (often measured as the 10-year yield minus the 2-year or 3-month yield) has come before most US recessions, though the timing can be long and varies a lot.
Steepening, flattening, bull and bear
Market commentary describes changes in the curve with two words.
Bull or bear tells you which way yields moved:
- Bull: yields fall (bond prices rise, which is good for bondholders).
- Bear: yields rise (bond prices fall).
Steepening or flattening tells you what happened to the gap between long and short yields:
- Steepening: the gap widens.
- Flattening: the gap narrows.
Put them together and you get four moves:
| Move | What happens | Typical cause |
|---|---|---|
| Bull steepening | Yields fall, short rates fall faster | The Fed is cutting because growth is weak |
| Bear flattening | Yields rise, short rates rise faster | The Fed is hiking to fight inflation |
| Bull flattening | Yields fall, long rates fall faster | The market expects a slowdown while the Fed holds rates high |
| Bear steepening | Yields rise, long rates rise faster | Growth or inflation expectations rise, or investors demand a bigger term premium |
Short rates follow the Fed. Long rates follow expectations for growth and inflation. Each of these moves is just a story about which of those two forces is moving faster.
How the curve moves through the business cycle
In my portfolio management class, we use the Investment Clock, a framework from Merrill Lynch (now BofA), which splits the business cycle into four phases based on whether growth and inflation are rising or falling. The yield curve has a typical shape in each phase:
| Phase | Growth | Inflation | Fed | Yield curve |
|---|---|---|---|---|
| Reflationary (early recovery) | Rising from below trend | Falling | Still very easy | Steep |
| Inflationary (overheating) | Above trend and rising | Rising | Starts hiking | Bear flattening |
| Stagflationary (slowing from the peak) | Falling | Still rising | Holds rates high | Flat or inverted |
| Deflationary (contraction) | Falling below trend | Falling | Cuts rates | Bull steepening |
A short way to remember it: hikes flatten the curve and cuts steepen it. “Bull” and “bear” just tell you whether yields are falling or rising while that happens.
Why this matters for stocks
The yield curve isn’t only a bond-market story. It shapes which parts of the stock market do well:
- Banks borrow short and lend long, so they earn more on a steep curve and struggle when it flattens or inverts.
- Insurers invest the premiums they collect in bonds, so higher yields lift their investment income.
- Utilities and real estate behave like bonds: steady payouts and lots of debt. They usually do better when yields fall.
- Long-duration growth stocks (like many tech companies) gain the most when yields fall and suffer the most when yields rise, as we saw in Part 1.
Key takeaways from Part 2
- The federal funds rate is the overnight rate banks charge each other. The FOMC sets a target range for it eight times a year.
- The Fed raises rates to fight inflation and cuts them to support employment. Its policy works with lags of up to two years.
- The Fed controls short rates. Long rates reflect expected future short rates, expected inflation and a term premium.
- Strong growth pushes long rates up, but by how much depends on how long the market expects that growth to last.
- The yield curve’s shape, and the way it steepens or flattens, tells you what the market expects from the Fed and the economy.
- Across the cycle: steep in recovery, bear flattening as the Fed hikes, flat or inverted near the peak, bull steepening as the Fed cuts.
In Part 3, I’ll work through a numerical example of why long rates price in the future, and use it to explain why financial stocks are so cyclical.