The September FOMC meeting marked a clear shift back toward a more explicitly inflation-focused policy stance, with the Fed unanimously raising rates 25-basis points to a target fed funds range of 3.75 percent to 4.00 percent and emphasizing resilient spending, productivity, and capital investment alongside inflation that remains elevated and potentially persistent. Sixteen of 18 policymakers see further tightening and the market is pricing roughly 75 basis points of additional hikes through June 2027. However, the case for aggressive follow-through is less straightforward because financial conditions have already tightened substantially through higher Treasury yields and mortgage rates.
The bond market’s response has therefore been relatively restrained: Treasuries and Agency MBS rallied modestly following the FOMC decision, particularly at the long end of the yield curve. This rally was helped by lower oil prices and the Bank of England’s decision to halt long-dated gilt sales, but the 10-year yield remains around historically elevated levels. Persistent Treasury supply, fiscal concerns, and the prospect of inflation remaining above target should continue to weigh on long-duration bonds, making a sustained move below 5 percent in the 30-year difficult absent a meaningful deterioration in economic growth or risk assets. Keep in mind that much of the anticipated Fed tightening is already reflected in market pricing, meaning yields would only drift lower if investors conclude that additional hikes would do little to restrain an economy still supported by solid demand and productivity.
August retail sales rose a stronger-than-expected 1.2 percent, with ex-auto and core measures also advancing 1.4 percent, while business inventories increased 0.8 percent, pointing to continued economic momentum. However, import and export prices accelerated, and the Philadelphia Fed’s prices-paid and prices-received measures jumped sharply. In other words, the economy is not showing the broad deterioration that would typically make further tightening unnecessary, but inflationary pressures from energy, trade, geopolitics, and strong investment demand remain potential obstacles to a rapid return toward the Fed’s 2 percent inflation target. August housing starts fell 2.6 percent month-over-month and building permits declined 2.7 percent, with single-family permits weakening across every region, while pending home sales rose only 0.3 percent. MBA’s August data likewise showed new-home purchase applications down 5.5 percent year-over-year and 6 percent from July, marking the fifth consecutive monthly decline. Mortgage rates near their highest levels since May 2025 are clearly constraining activity.
The combination of higher rates and weakening housing demand has an important technical consequence: roughly 98 percent of 30-year borrowers reportedly now lack a refinancing incentive. This sharply reduces expected prepayments and causes portions of the mortgage universe (particularly higher-coupon 5.5 percent securities, with 4.5 percent coupons approaching the same threshold) to move toward positive convexity rather than the negative convexity normally associated with MBS. That dynamic can make duration more stable as rates rise. Meanwhile, the broader slowdown in refinancing, especially among government borrowers, with VA refinances down 77 percent over six months, shows how firmly higher rates have altered borrower behavior. Overall, the market is balancing a Fed that has regained an inflation-fighting posture against an economy resilient enough to withstand tighter policy, but a housing sector increasingly showing the cumulative cost of restrictive financial conditions.
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