Rarely seen for decades! The reason behind the heated debate on Wall Street when the Fed cut interest rates and US bond yields climbed

The Zhitong Finance App learned that the US Treasury bond market's reaction to the Fed's interest rate cut is extremely unusual. By some measures, such a clear divergence — that is, US bond yields continued to rise while the Federal Reserve cut interest rates — has not occurred since the 90s of the last century. What this divergence means has sparked heated debate. There are a variety of opinions, from optimism (showing that the market is confident that the economy will not fall into recession), to neutral (returning to the normal state of the market before 2008), to the explanation most favored by the so-called “bond police” (investors lose confidence in whether the US can control the ever-expanding treasury bonds).

10-year US Treasury yields have continued to rise since the Federal Reserve began cutting interest rates in 2024

One thing is clear, however — the bond market doesn't agree with US President Trump's view that faster interest rate cuts will cause US bond yields to fall, which in turn will lower interest rates on mortgages, credit cards, and other types of loans. As Trump will soon be able to replace Federal Reserve Chairman Powell with his own candidate, another risk is that the Fed may succumb to political pressure and relax monetary policy more aggressively, thereby damaging its credibility — which could backfire, drive up already high inflation, and further boost US bond yields.

Steven Barrow (Steven Barrow), head of monetary strategy at Standard Bank Group of Ten (G10), said: “The core goal of Trump's second term was to reduce long-term yields. But putting a politician in the Federal Reserve won't lower bond yields.”

The Federal Reserve began lowering the federal funds rate from a 20-year high in September 2024. So far, it has cut interest rates by 150 basis points, making it 3.75%-4%. Traders have fully calculated that the Federal Reserve will cut interest rates by another 25 basis points this Wednesday, and generally expect to cut interest rates by 25 basis points twice next year, bringing the benchmark interest rate down to 3.00%-3.25%.

However, the yield on US Treasury bonds, which is the main benchmark for US consumer and corporate borrowing costs, has not declined at all. Since the Federal Reserve began easing monetary policy, the 10-year US Treasury yield has risen by nearly half a percentage point to 4.1%, and the 30-year US Treasury yield has risen by more than 0.8 percentage points.

Normally, when the Federal Reserve raises or lowers short-term policy interest rates, long-term bond yields tend to change accordingly. Even in the only two non-recessionary interest rate cut cycles in the past 40 years (1995 and 1998, when the Federal Reserve cut interest rates by 75 basis points each time), the 10-year US Treasury yield either declined or increased far less than the current rate cut cycle.

Jay Barry (Jay Barry), head of global interest rate strategy at J.P. Morgan Chase, believes there are two main factors behind it. First, during the post-pandemic period of soaring inflation, the Fed raised interest rates so much that the market had absorbed loose expectations ahead of schedule before the Fed actually switched, and 10-year US Treasury yields peaked at the end of 2023. This weakened the impact of interest rate cuts after they began. Furthermore, the Federal Reserve chose to cut interest rates sharply while inflation was still high, which actually reduced the risk of recession, thus limiting the room for US bond yields to decline. Barry said, “The Federal Reserve's intention is to maintain this round of economic expansion, not to end it. That's why US bond yields haven't declined significantly.”

Others see an even less optimistic explanation from the so-called term premium (term premium) — that is, investors require additional compensation when holding long-term bonds to cover possible future risks (such as high inflation or unsustainable fiscal deficits). According to estimates from the New York Federal Reserve, since the beginning of the interest rate cut cycle, the term premium has risen by nearly 1 full percentage point.

Term premiums have dominated yield changes since the Federal Reserve first cut interest rates this week

Bianco Research President Jim Bianco (Jim Bianco) believes this is a sign that bond traders are concerned that the Federal Reserve will continue to cut interest rates while inflation remains stubbornly above the 2% target and the economy continues to ignore recession expectations. “The market is indeed concerned about the policy and is worried that the Federal Reserve has gone too far,” he said. He added that if the Federal Reserve continues to cut interest rates, mortgage interest rates will “rise vertically.”

Furthermore, the market is worried that Trump (which is very different from his predecessor's approach of respecting the independence of the Federal Reserve) will successfully pressure policymakers to continue cutting interest rates. Kevin Hassett, director of the White House National Economic Council and a loyal supporter of Trump, is currently the most likely candidate to replace Powell after his term in May according to current betting market predictions.

Markets Live strategist Ed Harrison (Ed Harrison) said, “If interest rate cuts increase the possibility of stronger economic growth, then interest rate cuts will not lead to lower US bond yields; on the contrary, they will bring higher US bond yields. In many ways, this is because we are returning to a normal interest rate system — 2% real return + 2% Fed inflation target = 4% long-term yield bottom line. Coupled with stronger growth, this number is only going to be higher.”

So far, however, the broader bond market has remained relatively stable. The 10-year US Treasury yield has been hovering around 4% for the past few months. The break-even inflation rate — the main measure of inflation expectations in the bond market — has also remained stable, indicating that market concerns that the Federal Reserve may trigger a spike in inflation in the future have probably been exaggerated.

Robert Tipp (Robert Tipp), chief fixed income investment strategist at global insurance asset management giant PGIM, said it looked more like a movement back to normal levels before the global financial crisis. The financial crisis began an era of long-term abnormally low interest rates, which came to an abrupt end after the pandemic. “We are back to a normal world of interest rates,” he said.

Standard Bank's Steven Barrow pointed out that the Fed's lack of control over long-term US bond yields reminded him of a similar dilemma faced by the Federal Reserve at the beginning of this century (albeit in the opposite direction) — the well-known “Greenspan mystery.” At the time, Federal Reserve Chairman Alan Greenspan was puzzled as to why long-term yields remained low while he continued to raise short-term policy interest rates. Greenspan's successor, Ben Bernanke, later attributed this “mystery” to the massive influx of excess overseas savings into US Treasury bonds.

Barrow said that now this dynamic has been reversed, and governments in major economies are borrowing too much. In other words, past savings surpluses have turned into an oversupply of bonds, which continues to put upward pressure on yields. He said, “The long-term yield may be in a state where it is structurally impossible to decline. At the end of the day, the Federal Reserve cannot determine long-term interest rates.”