Beyond the Fed: The Two Forces That Drive Interest Rates

Michael Sheldon, CFA®, CFP®
Vice President and Senior Portfolio Manager
Washington Trust Wealth Management

When you hear about interest rates in the news, the conversation usually centers on the Federal Reserve and its latest policy decisions. But the Fed is only part of the story. While the Federal Reserve controls short-term rates, long-term rates are determined by the market. Understanding the differences and the relationship between the two can help you interpret what's happening in the economy and what it may mean for your investments.

The Fed and Short-Term Rates

Short-term interest rates are controlled by the Federal Reserve. Members of the Federal Open Market Committee (FOMC) meet eight times each year to decide whether to lower, raise, or leave interest rates unchanged, while also discussing other important economic and market developments.

The Federal Reserve directly controls the federal funds rate, which is the rate banks charge one another for overnight lending. Other important short-term rates, including the Prime Rate and three-month U.S. Treasury bill yields, have historically tracked changes in the federal funds rate over time.

As of June 30, 2026, the federal funds target range was 3.50% to 3.75%. ⁱ

At the start of the year, many investors expected the Fed to continue reducing rates. However, expectations have shifted, and some now believe there is a possibility that rates could move higher instead of lower in the months ahead. Much will depend on the future path of inflation.

The Market and Long-Term Rates

Unlike short-term rates, long-term interest rates are set by the market rather than the Federal Reserve.

The most closely watched benchmark monitored by global investors is the yield on the 10-year U.S. Treasury note. That yield reflects changes in Fed policy, the outlook for inflation, stronger or weaker economic data, rising or falling government debt levels, market uncertainty, risk tolerance levels, and changes in the U.S. dollar. As those expectations change, long-term interest rates move with them.

As of the close on June 30, 2026, the 10-year U.S. Treasury yield stood at 4.40%. ⁱⁱ

Why the Spread Matters

Market participants closely monitor not only short- and long-term rates, but also the spread between them for important signals about the economy and financial markets.

Historically, a narrowing spread has often reflected a more cautious investment environment. That can occur when the Fed is raising short-term rates, when the economy is slowing and longer-term rates decline, or when investors become more cautious during periods of market uncertainty.

On the other hand, a widening spread has generally reflected greater investor confidence and a more favorable environment for financial assets. However, it is not always an entirely positive signal. A widening spread can also indicate that investors are becoming more concerned about inflation. For example, excessive government spending or an overheating economy could increase inflation expectations, causing investors to demand higher yields on long-term Treasury securities.

As of June 30, 2026, the spread between the federal funds rate and the 10-year U.S. Treasury yield was 0.65%, compared with 0.42% at the end of 2025 and a 10-year average of 0.32%. ⁱⁱⁱ

What It Means for Your Portfolio

Interest rates influence much more than the bond market. They affect mortgage rates, savings yields, business borrowing costs, stock valuations, and ultimately the pace of economic growth. That's why understanding how short- and long-term rates interact can provide valuable perspective for investors.

Today, the positive spread between short- and long-term may reflect expectations for continued economic growth over the next several quarters. At the same time, inflation remains an important variable to watch. If inflation stays above the Federal Reserve's stated 2% target or begins moving higher again, the yield curve could continue to widen if investors believe the central bank is not acting aggressively enough to address future inflation pressures.

In summary, changes in short and long-term U.S. Treasury yields matter.  However, it can also be helpful to monitor how short- and long-term rates move versus each other.  This relationship provides valuable insight into how investors view economic growth, inflation, and future monetary policy—and that broader perspective can help you make more informed long-term investment decisions.

Washington Trust Wealth Management: Making Sense of a Complex Market

Whether interest rates are rising, falling, or remaining steady, your Washington Trust Wealth Management advisor can help you cut through the headlines, put market developments into context, and make informed portfolio decisions that align with your long-term financial goals. By taking a disciplined, long-term approach tailored to your financial goals, we can help you make informed decisions with confidence, regardless of the market environment.