How Low Can Treasury Yields Go? Navigating Inflation, Fiscal Deficits, and Fed Policy Constraints

The U.S. Treasury market has long served as a barometer for global economic stability, but in 2025, investors face a complex landscape of constraints limiting the downside potential of bond yields. Despite a recent softening in inflation and expectations of Federal Reserve rate cuts, persistent macroeconomic pressures—including stubborn inflation, ballooning fiscal deficits, and a cautious Fed—suggest that Treasury yields will remain anchored at elevated levels. This analysis explores how these forces interact to cap yield declines, offering insights for investors navigating this environment.

Inflation: A Persistent Floor for Yields

While the U.S. 10-year Treasury yield dipped to 4.08% on September 9, 2025, down from 4.25% in June, this modest decline masks a broader reality: inflation remains a formidable barrier to yield compression. As of August 2025, the annual inflation rate is projected to reach 2.9%, with core inflation (excluding food and energy) holding steady at 3.1% What To Expect From Tomorrow's CPI Inflation Report^[6]. These figures exceed the Federal Reserve's 2% target, ensuring that long-term yields remain insulated from significant downward pressure.

The Federal Reserve's June 2025 Monetary Policy Report underscores this dynamic, noting that "consumer price inflation continues to ease, but core PCE inflation remains elevated at 2.5%, reflecting persistent price pressures in services and durable goods sectors" Monetary Policy Report – June 2025^[2]. Even as the Fed contemplates rate cuts later in the year, the risk of inflation reacceleration—driven by sectors like medical care and transportation services—limits the scope for aggressive monetary easing.

Fiscal Deficits: A Rising Risk Premium

The U.S. fiscal deficit has emerged as another critical constraint on Treasury yield declines. By July 2025, the federal deficit had ballooned to $1.6 trillion, with revenues and outlays both rising by 5–6% year-over-year Deficit Tracker^[1]. This trajectory has heightened investor concerns about debt sustainability, prompting a risk premium in long-term yields. According to a report by the Brookings Institution, "each percentage point increase in the debt-to-GDP ratio raises long-term interest rates by approximately 3 basis points, directly crowding out private investment" The Rise in Long-Term US Treasury Yields^[5].

The One Big Beautiful Bill Act (OBBBA), enacted in July 2025, exemplifies this tension. While the legislation provides a short-term GDP boost, its long-term fiscal implications are dire. Projections indicate that the 10-year Treasury yield could be 1.4 percentage points higher by 2054 under the OBBBA scenario compared to a baseline without the act Long-term Impacts of the One Big Beautiful Bill Act, as...^[4]. This structural shift in investor sentiment has already manifested in a steepening yield curve, with the spread between five-year and 30-year Treasuries reaching levels not seen since 2021 Deficit Tracker^[1].

Fed Policy: A Delicate Balancing Act

The Federal Reserve's 2025 policy stance reflects a cautious, data-dependent approach. At its July meeting, the FOMC maintained the federal funds rate at 4.25–4.50%, emphasizing its commitment to "monitoring inflation and employment data while balancing its dual mandate of price stability and maximum employment" Long-term Impacts of the One Big Beautiful Bill Act, as...^[4]. This hesitation is rooted in two key uncertainties: the lingering effects of import tariffs and the fiscal deficit's impact on long-term growth.

Tariff-driven inflation has introduced volatility into the economic outlook. While wholesale inflation (as measured by the PPI) has cooled, core PPI inflation (excluding food and energy) rose 0.3% in August 2025, signaling that businesses are beginning to pass on cost increases to consumers PPI inflation August 2025: Prices unexpectedly declined ...^[3]. Meanwhile, the Fed's forward guidance suggests that rate cuts—anticipated as early as September—will be incremental, with markets pricing in a 87% chance of a 25-basis-point reduction Long-term Impacts of the One Big Beautiful Bill Act, as...^[4]. This measured approach ensures that Treasury yields remain range-bound, fluctuating between 4.1% and 4.7% as of August 2025 PPI inflation August 2025: Prices unexpectedly declined ...^[3].

Conclusion: A Cap on Yield Declines

For investors, the interplay of inflation, fiscal deficits, and Fed policy creates a clear floor for Treasury yields. While short-term volatility is inevitable, the structural forces outlined above suggest that meaningful declines—below 4.0%—are unlikely in 2025. The Federal Reserve's independence and global demand for U.S. Treasuries provide some stability, but these advantages are increasingly offset by fiscal imbalances and inflationary risks.