Federal Reserve Rate Cuts May Steepen U.S. Yield Curve by 100 Basis Points

The global financial markets are closely monitoring the potential impact of the Federal Reserve's interest rate cuts on the yield curve. According to the global sovereign debt portfolio manager at DoubleLine Capital, if the Federal Reserve implements aggressive rate cuts, the U.S. yield curve is likely to steepen further. This steepening is expected to encourage riskier lending behaviors, potentially prolonging the period of high valuations for risk assets.

Currently, the 2-year U.S. Treasury yield is near its lowest level since 2022, while the 10-year U.S. Treasury yield is at its lowest point in five months, driven by market expectations of rate cuts. This situation could maintain high trading prices for risk assets and credit assets. The most evident manifestation of these issues could be a weakening dollar and a steepening yield curve.

This year, long-term U.S. Treasuries have performed poorly, leading to a widening of the yield curve to its highest level in years. The spread between 2-year and 10-year U.S. Treasury yields is currently around 58 basis points, compared to just 20 basis points at the end of February. This difference could increase by another 75 to 100 basis points over the entire market cycle, as investors anticipate that the Federal Reserve will be more tolerant of inflation and more inclined to ease policy in the face of increasing debt supply. This would match the near 158 basis point spread seen in March 2021.

Last Friday's disappointing U.S. non-farm payroll data has reinforced expectations that the Federal Reserve will need to act quickly to support the labor market, with traders anticipating nearly three rate cuts this year. The next rate decision is scheduled for September 17. The pressure on the Federal Reserve to act quickly is not limited to the labor market; the U.S. government also faces a significant burden of maturing debt in the coming years, much of which was borrowed at lower interest rates.

Next year, over 3.4 trillion U.S. dollars in Treasury debt will mature, with an average interest rate of 2.78%, significantly lower than the current 2-year yield of 3.5% or the 10-year yield of 4.07%. If the U.S. Treasury Department refinances this maturing debt at current 2-year rates, taxpayers would face an additional 25 billion U.S. dollars in interest costs annually. This is just one of the pressing issues. The total amount of U.S. Treasury debt outstanding is approximately 29 trillion U.S. dollars, with much of it issued at lower interest rates. As this debt matures, the U.S. Treasury Department plans to issue more short-term debt to avoid locking in interest rates at 4% for the next few decades, further tying U.S. borrowing costs to Federal Reserve policy.

Rising fiscal deficits and long-term funding costs are putting pressure on countries around the world. The U.S. Treasury Secretary has discussed the goal of lowering the 10-year U.S. Treasury yield to make it easier for Americans to obtain mortgages or car loans. However, this is seen as a challenging task. The manager at DoubleLine Capital stated that reducing the yield on 10-year bonds to 3% would be quite difficult.