Rare disagreement in the US bond market: Long-term bond yields rise instead of fall on the eve of rate cuts

Author: Long Yue, Wall Street Insights

Since the Federal Reserve began this round of rate cuts in September 2024, it has cumulatively lowered the benchmark interest rate by 1.5 percentage points to a range of 3.75%-4%. However, market reactions have been unexpected. During the same period, the yield on the 10-year U.S. Treasury rose by nearly 0.5 percentage points to 4.1%, while the 30-year Treasury yield increased by more than 0.8 percentage points.

This trend directly challenges the traditional market logic that Fed rate cuts usually lead to a decline in long-term interest rates. It also contradicts the expectations of U.S. President Trump, who believed that faster rate cuts would effectively lower mortgage, credit card, and other loan rates. The market’s abnormal performance indicates a significant divergence between investors’ interest rate outlooks and the Federal Reserve’s stance.

Currently, there are diverse opinions on how to interpret this divergence. Optimists see it as a sign of confidence that the economy will avoid a recession; neutral observers view it as a return to pre-2008 financial crisis normalcy in market interest rates; while pessimists worry that it reflects a re-emergence of the “bond vigilantes,” who are skeptical of the U.S.'s growing national debt and potential inflation risks.

Rare Divergence: Rising Yields During a Rate Cut Cycle

Typically, when the Fed adjusts its short-term policy rate, long-term bond yields tend to move accordingly. However, this cycle’s performance has broken that norm.

Data shows that traders generally expect the Fed to cut rates by another 25 basis points after this week’s meeting, with two more similar cuts expected next year, bringing the policy rate to around 3%.

Yet, the key Treasury yields that serve as benchmarks for consumer and corporate borrowing costs in the U.S. have not declined accordingly.

Looking back at the only two rate cut cycles outside of recessions in the past forty years (1995 and 1998), the Fed cut rates by only 75 basis points at most, and the 10-year Treasury yield either directly declined or increased far less than current levels.

Soft Landing or Return to Normal?

Regarding the reasons for the rising yields, Jay Barry, head of global interest rate strategy at J.P. Morgan, attributes two factors.

First, the unprecedented rate hikes taken by the Fed in the post-pandemic era to curb inflation have already been priced in by the market before the Fed actually begins cutting rates, causing the 10-year yield to peak at the end of 2023.

Second, he notes that the Fed’s rate cuts while inflation remains high aim to “maintain this economic expansion rather than end it,” which reduces the risk of recession and limits the downward space for yields.

Robert Tipp, Chief Investment Strategist at PGIM Fixed Income, shares a similar view, suggesting this is more like a “return to normal,” with interest rates returning to pre-2008 global financial crisis levels. That crisis marked the start of an unusually low-interest-rate era, which has abruptly ended post-pandemic.

Inflation Concerns and the Return of “Bond Vigilantes”

However, some market participants see more troubling signals in the so-called “term premium.” The term premium is the extra yield investors demand for holding long-term bonds to hedge against future inflation or default risks. According to the New York Fed’s estimates, since this rate cut cycle began, the premium has increased by nearly one percentage point.

Jim Bianco, President of Bianco Research, believes this is a clear signal that bond traders are worried about the Fed cutting rates too quickly amid stubbornly high inflation and resilient economic performance. He warns: “What the market is truly concerned about is this policy itself,” and if the Fed continues to cut rates, mortgage rates could “spike vertically.”

Additionally, political factors have heightened market concerns. There are fears that President Trump might successfully pressure the Fed to adopt more aggressive rate cuts. According to Bloomberg, Jared Bernstein, director of the National Economic Council under the White House and a loyal supporter of Trump, is viewed as a potential successor to Chair Powell in betting markets. Steven Barrow, G10 Strategist at Standard Bank, bluntly states: “Having a politician in charge of the Fed will not cause bond yields to fall.”

From “Greenspan Conundrum” to Surplus Supply: Structural Changes Are Occurring?

Deeper analysis points to structural shifts in the global macroeconomy. Standard Bank’s Barrow compares the current situation to a mirror image of the mid-2000s “Greenspan conundrum.”

At that time, Fed Chair Alan Greenspan was puzzled by the phenomenon of continued rate hikes while long-term yields remained low.

His successor, Ben Bernanke, later attributed this to a surge of excess savings from overseas into U.S. Treasuries. Now, Barrow believes the situation is quite the opposite: the scale of government borrowing in major economies worldwide is too large, and the former “savings surplus” has transformed into a “bond supply surplus,” exerting persistent upward pressure on yields.

Barrow concludes: “Yields not falling may be a structural change. Ultimately, long-term interest rates are not determined by central banks.”