U.S. Treasury Yield Declines Amid Inflation Relief and Trade Tensions

The recent dip in U.S. Treasury yields reflects a nuanced interplay of inflation moderation, trade policy uncertainty, and fiscal risks. While the 10-year Treasury yield has retreated to 4.29% as of June 27—a decline from its March peak of 4.51%—this move masks deeper macroeconomic crosscurrents. Investors must parse these dynamics to navigate bond markets and equity valuations effectively.

The PPI Data: A Mixed Signal of Inflation Relief

The May 2025 Producer Price Index (PPI) release provided a critical update on producer-level inflation. While headline PPI rose just 0.1% month-over-month, annual inflation slowed to 2.6%, the lowest since early 2021. This moderation was driven by declines in agricultural commodities (e.g., grains fell 7.8%) and energy inputs (e.g., carbon steel scrap dropped 9.5%). However, tariff-driven cost pressures remain a wildcard: steel mill product prices surged 7.1%, reflecting the impact of U.S. tariffs on imported steel and aluminum.

The core PPI (excluding food and energy) edged up 0.1%, but annualized core inflation eased to 3.0%—a sign that persistent cost pressures from wage growth and shelter costs are abating. This has calmed bond markets, with traders pricing in a higher probability of Fed rate cuts by year-end.

Trade Tensions: A Sword of Damocles Over Yields

While PPI data hints at inflation relief, trade policy risks threaten to reverse this progress. The U.S. reimposition of 50% tariffs on steel and aluminum imports in early 2025 has created a “cost-push” inflation dynamic. Industries such as automotive, construction, and aerospace face rising input costs, which could spill into consumer prices.

Show me the correlation between steel price volatility and U.S. Treasury yields since 2022

Furthermore, stalled U.S.-China trade negotiations and retaliatory tariffs from trading partners have exacerbated supply chain disruptions. This uncertainty keeps a “risk premium” embedded in Treasury yields, particularly in long-dated maturities. The 10-year/2-year yield spread, a key recession indicator, narrowed to 0.56%, signaling market skepticism about the durability of the inflation slowdown.

Fiscal Deficits and Treasury Funding Risks

The U.S. Treasury's borrowing needs add another layer of complexity. Projections for $514 billion in Q3 2025 borrowing (assuming debt limit resolution) could amplify term premiums if investor demand falters. The Treasury Borrowing Advisory Committee (TBAC) has warned that prolonged debt limit brinkmanship risks destabilizing markets and raising borrowing costs.

Plot the U.S. debt-to-GDP ratio versus 10-year Treasury yields since 2020

The debt limit debate also introduces political risk. A failure to raise the limit would trigger technical defaults on Treasury bills, potentially causing a spike in yields and a collapse in bond prices. This tail risk favors shorter-duration bond allocations.

Implications for Bond Markets: Favor Intermediate Maturities

The current environment calls for a barbell strategy in Treasurys:
- Overweight intermediate maturities (5–7 years): These bonds benefit from falling yields while avoiding the fiscal and inflation risks embedded in long-dated bonds. The 5-year Treasury yield (currently ~3.85%) offers a yield cushion with reduced duration exposure.
- Underweight long-dated Treasurys (10+ years): The 30-year yield at 4.85% still faces upward pressure from persistent core inflation and fiscal deficits. A resurgence in tariffs or a growth rebound could reignite inflation, further widening spreads.

Equity Markets: Focus on Sectors with Pricing Power

For equities, the yield decline has supported valuations, but sector selection is critical:
- Favor inflation-resistant sectors: Energy (受益于高钢价和资源需求) and healthcare (受益于稳定需求) can pass cost increases to consumers.
- Avoid rate-sensitive sectors: Utilities and REITs face headwinds as lower yields compress dividend yields.

Conclusion: Navigating Crosscurrents

The decline in Treasury yields reflects both inflation relief and heightened uncertainty. While intermediate Treasurys offer a tactical opportunity, long-dated bonds remain vulnerable to fiscal and trade risks. Investors should pair bond allocations with equity sectors insulated from supply chain disruptions. As the Fed's policy path and trade negotiations evolve, staying agile—and short—will be key.

Show the correlation between the S&P 500 and 10-year Treasury yields since 2020

In this environment, patience and diversification are paramount. The bond market's next move will hinge on whether inflation moderation outpaces trade-related volatility—and whether fiscal policymakers can avoid the next debt ceiling cliff.