How Will Falling Treasury Yields Affect Potential Fed Rate Hike?

On Friday, the Dow Jones Industrial Average suffered its biggest two-day point drop since the 2008 financial crisis. The Dow plummeted over 1,000 points last week -- the worst week since 2011.

Volatile equities markets and worries about the global economic slowdown are driving investors into safe havens.

Treasury yields dropped Friday for a third straight day, with the 10-year yield posting its largest weekly decline in five months and finishing at a nearly four-month low.

The yield on the 10-year Treasury declined 3.1 basis point to 2.052% on Friday, its lowest point since April 30.

Demand for Treasuries drives down yields. The US doesn’t need to induce desperate investors to buy when fear does that all by itself.

So, how might this affect the Fed's long-held plan to raise its key interest rate, which has been stuck at or below 0.25 percent since December 2008?

If Treasury yields are falling on their own, would the Fed essentially be in the position of trying to hold back the tide with a rate hike?

Or, would the Fed feel empowered to raise the funds rate since the downward pressure on yields would give them some cover, and room to maneuver?

The combination of lower international yields and higher Treasury yields has already increased investor demand, both foreign and domestic. Higher demand pushes yields lower.

Another consideration for the Fed is the continuing strength of the dollar, which makes dollar-denominated fixed-income assets additionally attractive.

A rate hike would draw in even more foreign money from around the world. The yield sharks are everywhere. And though Treasuries may be falling, they are still higher than yields in much of Europe and Japan, the other perceived “safe” zones.

For example, the German 10-year bund was yielding just 0.565% last week.

Raising the federal funds rate would surely create a flood of hot money into the US, searching for the combination of higher yield and safety.

That would crush already suffering emerging markets, which have been experiencing an exodus of investor money.

Moreover, the strong dollar is already punishing US exporters. American-made goods are less competitive against cheaper foreign goods.

A move higher in rates would only exacerbate the problem, raising the trade deficit even further.

An interest rate hike would also add to deflationary forces. In simple terms, a stronger dollar increases the risk of deflation.

Oil, which is priced in dollars, is already falling due to excess global supplies and weaker global demand. A stronger dollar would make oil even cheaper in the US.

That would be great for American drivers, but awful for US oil companies. The US is the No. 3 crude producer in the world. A lot of jobs and tax revenue are derived from the domestic oil industry.

The Fed has been expected to raise interest rates all year, something it hasn’t done in over nine years. But a combination of deflationary forces and a stumbling economy have kept policy makers from acting.

The Fed surely wants a higher funds rate in order to confront the next financial/economic crisis. We all know it’s coming.

With rates currently just above zero, the only place to go in the event of such a crisis would be zero, or even negative.

That’s a nightmarish scenario.

So, while the Fed is desperate to raise rates, outside forces are tying its hands, and are in fact driving rates down instead.