The Fed lower rates of interest final week, however Treasury yields are rising. What's up?

Construction takes place around the Federal Reserve building in Washington, DC on September 17, 2024.

Anna Moneymaker | Getty Images News | Getty Images

With its above-average interest rate cut last week, the Federal Reserve sent a clear signal that interest rates will fall significantly in the future.

However, the Treasury market did not pay attention.

Although the Fed agreed to cut its base short-term lending rate by half a percentage point, Treasury yields have instead risen, particularly at the long end of the curve.

The 10-year Treasury yield, considered the benchmark for Treasury yields, has risen about 17 basis points since the Federal Open Market Committee meeting on Sept. 17 and 18 – reversing a sharp decline in September. One basis point is equal to 0.01%.

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10-year yield rises

For now, bond market experts believe much of this measure is simply an excuse for markets to price in too much easing ahead of the Fed meeting. However, the trend is worth keeping an eye on as it could indicate something more sinister.

Other reasons cited for the move include the Fed's willingness to tolerate higher inflation, as well as concerns about the precarious fiscal situation in the U.S. and the possibility that high debt and deficit burdens could increase long-term borrowing costs no matter what the Fed does .

“To some extent there was just an element of people buying the rumor and selling the facts as they related to the actual FOMC decision last week,” said Jonathan Duensing, head of US fixed income at Amundi US . “The market had already priced in a very aggressive easing cycle.”

In fact, the market had priced in larger rate cuts than Fed officials had indicated at the meeting, even with the 50 basis point change. Officials planned another 50 basis points of cuts by the end of the year and another 100 basis points by the end of 2025. In contrast, markets expect another 200 basis points of cuts over the same period, according to Fed Funds futures prices measured by the CME Group's FedWatch tracker.

But while longer-dated bonds like the 10-year bond saw yields rise, bonds at the shorter end of the curve followed suit – including those closely following 2 year grade – didn’t move much at all.

This is where things get tricky.

Watch the curve

The difference between the 10-year and 2-year bonds has widened significantly, rising by about 12 basis points since the Fed meeting. This move, particularly when longer-term yields rise more quickly, is known in market parlance as a “bear steepener.” This is because this generally coincides with the bond market anticipating higher inflation.

That's no coincidence: Some bond market experts interpreted Fed officials' comments that they are now more focused on supporting the weakening labor market as an admission that they are willing to tolerate slightly higher inflation than normal.

This sentiment is reflected in the “breakeven” inflation rate, or the difference between standard yields on Treasury bonds and Treasury inflation-protected bonds. For example, the 5-year breakeven rate has increased 8 basis points since the Fed meeting and 20 basis points since 9/11.

“The Fed has rightly reversed course because it believes inflation is under control, but it is seeing a rise in unemployment and a rate of job creation that appears clearly inadequate,” said Robert Tipp, Chief Investment Strategist at PGIM Fixed Income. The rise in long-term yields “is definitely an indication that the market sees the risk of higher inflation.” [the Fed] You won’t care.”

Fed officials are targeting an inflation rate of 2%, and none of the key indicators have yet been achieved. The closest is the Fed's preferred personal consumption expenditures price index, which was 2.5% in July and is expected to be 2.2% in August.

Policymakers insist they are equally focused on ensuring inflation doesn't turn around and rise, as it has in the past when the Fed was too quick to ease.

However, markets expect the Fed to focus more on the labor market and be careful not to push the overall economy into an unnecessary slowdown or recession by tightening too much.

There is a possibility of major cuts

“We’re taking the Fed and the chairman together [Jerome] “Powell has said they will be very data dependent,” Duensing said. “As far as the slowdown in the labor market is concerned, they are very willing and interested to cut another 50 basis points here when we start contributing.” -Election meetings are coming up. They are prepared to approve any necessary adjustments at this time.

Then there are the debt and deficit problems.

Higher borrowing costs pushed the cost of financing the budget deficit above $1 trillion for the first time this year. While lower interest rates would help ease this burden, buyers of longer-dated Treasury bonds may be wary of investing in a fiscal situation in which the deficit approaches 7% of gross domestic product, virtually unheard of during the U.S. economic expansion.

Overall, the different dynamics in the Treasury market make it a difficult time for investors. All fixed income investors surveyed for this article said they are reducing their allocations to government bonds as conditions remain volatile.

They also believe the Fed may not be done with big rate cuts just yet.

“When we start to see that [yield] “As the curve gets steeper, that's probably when we start to sound the alarm bells about recession risks,” said Tom Garretson, senior fixed income portfolio strategist at RBC Wealth Management. “They would probably still like to pull off at least another 50-base point shift this year. There is still a lingering fear that they will be a little late to the game.”