Fed Cut Rates, but Treasury Yields Are Higher. Why?

Lawrence Gillum:

Fixed income investors may be feeling a little perplexed lately. After months of anticipation, the Federal Reserve finally cut interest rates last month. But since then, Treasury yields are generally higher. The reason? Not only were markets expecting the rate cut, the bond market expects even more rate cuts over the course of the next 12 months. So, in this Street View video, we take a look at what the market currently expects from the Fed and how that could influence the level of interest rates in the Treasury market. After enduring the most aggressive rate hiking cycle in decades, fixed income investors were likely thinking it would be an easy road to lower yields and higher prices. Unfortunately, that hasn't happened. In fact, since the recent lows on September 16, which was two days before the Fed officially cut interest rates, the 10-year Treasury yield is higher by nearly half a percent.

Lawrence Gillum:

Whereas the monetary policy sensitive two-year yield, it's higher by 0.42%. The reason? Many financial markets are forward looking so markets tend to price in the prospects of, in this case, rate cuts before they actually occur. In fact, bond markets were already pricing in an aggressive rate cutting cycle by the Fed with the expectation that the fed funds rate would be below 3% by next July. Markets expected the Fed to cut rates eight times before the rate-cutting campaign even started. Now though, with economic data coming in better than expected, those aggressive rate-cutting expectations are getting unwound, and that's what's pushing Treasury yields higher. Currently, which is the copper line, markets still expect the Fed to cut rates, just not as many cuts as previously, and after last week's slightly higher than expected inflation report markets are pricing in a small chance the Fed will skip the November meeting.

Lawrence Gillum:

So after weeks of markets, in our view, pricing in too many rate cuts throughout 2025, Fed rate cut pricing is better aligned with the economic data, which should keep Treasury yields generally anchored. So what's next? History shows that without signs of recession, intermediate and longer-term yields tend to drift higher. Our base case remains no recession this year, and our year-end target for the 10-year Treasury yield is 3.75 to 4.25. So right around current levels. And while yields may move slightly higher from current levels, we still think we're past peak Treasury yields for the cycle. And for those investors disappointed that rates haven't fallen, for fixed income returns generally come from two sources, income and price appreciation. Income is primarily based upon coupon payments from underlying bond holdings, whereas price appreciation comes from changing interest rates, mostly Treasury yields. And Treasury yields had fallen recently in anticipation of the Fed cutting interest rates.

Lawrence Gillum:

So it isn't surprising that yields are now moving higher. As mentioned, the bond market still has a pretty aggressive Fed rate cutting cycle priced in. So absent signs of further economic cooling, intermediate and longer-term rates may consolidate around current levels or may actually move slightly higher as the Treasury yield curve goes back to upward sloping. And that will likely limit the potential for price appreciation in the near term. But if the economy, particularly the labor market, cools more than expected, or if geopolitical events cause the Fed to accelerate rate cuts more than what is priced in, Treasury yields will likely fall and generate that price appreciation. Historically, fixed income returns have come primarily from the income component and with income levels still relatively attractive, we think clipping coupons is still an attractive strategy, especially versus cash. Thanks for listening.