Treasury Yields Defy Fed Cuts: Bond Market Braces for Uncharted Waters

In a seemingly paradoxical scenario, the U.S. Treasury market has reacted counterintuitively to the Federal Reserve’s aggressive rate cuts, witnessing a rise in yields. Since central banks began slashing benchmark rates dramatically in September, the yield on the 10-year U.S. Treasury has climbed by over 75 basis points. This marks the largest increase in the first three months of a rate-cutting cycle since 1989.

Bond investors, having rarely seen such downturns during periods of monetary easing by the Fed, are bracing for similar trends heading into 2025. With the Fed's third consecutive rate cut, the yield on the 10-year Treasury spiked to its highest in seven months. This came after policymakers hinted at a more gradual pace of monetary easing next year under the leadership of Federal Reserve Chairman Jerome Powell.

The yield surge highlights the distinctiveness of the current economic and monetary cycle. Despite increasing borrowing costs, a robust U.S. economy keeps inflation above the Fed’s target, prompting traders to adjust their expectations for significant rate cuts and instead prepare for disappointments. Currently, U.S. Treasury investments are teetering on the edge of breakeven.

A previously effective strategy during easing cycles, known as curve steepening—betting on short-term Treasuries’ outperformance over long-term ones—has regained traction. The difference between the 10-year and 2-year Treasury yields widened to 25 basis points, showing signs of steepening not seen since 2022.

Market participants have realigned their rate expectations, now anticipating a total rate cut of approximately 37 basis points next year, contrary to the Fed’s projection of 50 basis points. As market appetite for longer-term bonds remains low, institutional investors like Morgan Stanley are advising clients against buying long-term treasuries, citing a lack of imminent economic data and anticipated light trading into year-end.

In an evolving environment, investors are increasingly seeing value in short-term bonds. With the 2-year Treasury offering yields comparable to three-month T-Bills, the prospect of the Fed cutting rates more than expected could lead to price appreciation. Thus, short-term bonds are perceived as protective assets amid high stock valuations.

Meanwhile, skepticism grows around long-term U.S. debt, heightened by ongoing inflation and strong economic performance. Upcoming policy changes under the new government, led by President-elect Trump, are expected to stimulate economic growth and inflation, exacerbating existing budget deficits.

Thus, asset managers are inclined to hold shorter-duration bonds, shaping the curve's steepening trend as they balance factors such as fiscal deficit projections, the Fed's rate expectations, and Trump’s policy uncertainties, anticipating continued market volatility in the foreseeable future.