Treasury Yield Curve Shifts and Equity Risk Premiums: Navigating the New Normal in 2025

The U.S. Treasury yield curve has become a focal point for investors in 2025, as its unusual "swoosh" shape-marked by declining short-term yields and rising long-term rates-signals a recalibration of market expectations. This shift, driven by the Federal Reserve's easing cycle and persistent inflation concerns, has compressed equity risk premiums, reshaping the risk-return landscape for global portfolios.

Bond Market Signals: A "Bull Steepening" in Focus

The yield curve's steepening, particularly the widening spread between 2-year and 10-year Treasuries, reflects a "bull steepening" dynamic. According to a report by the St. Louis Fed and a related academic study, this pattern typically arises when central banks respond to disinflationary pressures rather than robust economic growth. Since the Fed began cutting rates in September 2024, the 10-year yield has surged to 4.6% as of January 2025, while the 2-year yield rose by 60 basis points, according to a Morningstar analysis. This divergence suggests investors now expect fewer future rate cuts and higher terminal rates, with the implied end-2025 federal-funds rate climbing to 3.75%-4.00% from earlier projections of 2.75%-3.00%, as noted by Morningstar.

The steepening is also fueled by rising real yields and inflation expectations. The 10-year TIPS yield and breakeven inflation rate have climbed in tandem, reflecting a market consensus that inflation will remain stubbornly above the Fed's 2% target, per Morningstar. Meanwhile, strong labor market data and fiscal policy uncertainty-such as concerns over U.S. debt sustainability-have reinforced long-term rate expectations, as explained in a Russell Investments note.

Equity Risk Premiums Under Pressure

The compression of equity risk premiums has been a direct consequence of these bond market dynamics. As Treasury yields rise, the cost of equity capital increases, narrowing the gap between stock earnings yields and bond yields. According to Morningstar, this has made equities appear relatively more expensive, particularly for growth stocks reliant on discounted future cash flows. The S&P 500's earnings yield (inverse of the price-to-earnings ratio) has fallen to levels last seen during the 2020 market rebound, squeezing the traditional risk premium that justifies equity ownership.

Sector rotations highlight the uneven impact. Energy, utilities, and defense stocks-sectors with higher yields and stable cash flows-have outperformed, while technology and other growth-oriented industries have lagged. This divergence aligns with historical patterns identified in academic studies: a global analysis of 60 countries found that stock markets with the highest bond yield volatility underperformed by 0.76% per month, a phenomenon unexplained by traditional risk factors, according to the ScienceDirect study.

Academic Insights: Linking Yield Curve Shifts to Equity Volatility

Quantitative models and historical case studies further illuminate the bond-equity nexus. A 2024 study on "yield news shocks" reveals that Treasury yield movements often lag behind macroeconomic developments, with shocks explaining up to 50% of yield variation years later, as documented by Morningstar. These shocks coincide with spikes in stock and bond volatility, as seen in 2025 when the yield curve steepened alongside heightened equity market turbulence, per Morningstar's analysis.

The San Francisco Fed's treasury yield decomposition offers additional clarity. As of September 2025, the 10-year yield includes an average expected overnight rate of 3% and a term premium of 1.15, reflecting investor aversion to long-term uncertainty, according to the San Francisco Fed. This term premium, which captures compensation for holding longer-maturity bonds, has historically correlated with equity risk premiums, as both reflect macroeconomic and policy risks, the San Francisco Fed analysis notes.

Investment Implications and the Road Ahead

For investors, the evolving yield curve signals a recalibration of asset allocation strategies. A steepening curve under a "soft landing" scenario-a moderate slowdown without recession-could support balanced portfolios, with equities and fixed income performing in tandem, according to a Lombard Odier analysis. However, a recessionary outcome would likely see further steepening and a flight to sovereign bonds, as observed in past downturns, as Lombard Odier also discusses.

Kroll's ERP update to 5.0% in June 2024 underscores the compressed risk premium environment. This adjustment reflects both the Fed's accommodative stance and the lingering effects of high inflation expectations, which have kept long-term yields elevated, as Russell Investments explains. Investors must also contend with the "yield curve vs. volatility cycle," where steepening curves often precede periods of rising equity volatility, a dynamic highlighted in analyses by Lombard Odier.

Looking ahead, the yield curve will remain a critical barometer. If the Fed's easing cycle fails to curb inflation or if fiscal strains intensify, long-term yields could rise further, exacerbating pressure on equity valuations. Conversely, a sustained soft landing could stabilize the curve and restore some equilibrium to risk premiums.

Conclusion

The interplay between Treasury yield curve shifts and equity risk premiums in 2025 highlights a market grappling with divergent signals. While the Fed's rate cuts have lowered short-term borrowing costs, long-term expectations of inflation and fiscal policy uncertainty have kept yields elevated. This dynamic has compressed equity risk premiums, forcing investors to reassess traditional valuation metrics and sector allocations. As the year progresses, monitoring the yield curve's evolution-alongside central bank actions and global macroeconomic data-will be essential for navigating the new normal in fixed income and equity markets.