Why have 10-year U.S. Treasury yields increased since the Fed started cutting rates?

Market update

A favorable inflation print this week has helped U.S. large cap equities erase all of this year's losses. 

Core consumer prices increased less than market expectations during the month of December. Month-over-month, the measure which excludes volatile food and energy prices increased 0.2%, bringing the year-over-year figure to 3.2%. That drove equity markets higher and bond yields lower. 

The S&P 500 (+1.9%) is heading to its first positive week of the year, the NASDAQ 100 (+1.2%) posted gains and small caps (Solactive 2000 +3.5%) outperformed. All 11 sectors in the S&P 500 closed higher, and seven of the 11 outperformed the broader index. 

Fourth quarter earnings season also kicked off this week with many companies in the financials sector reporting. The results, so far, are solid. In general, revenues were higher and financial firms showed discipline when it came to expenses. A strong year for investment performance fueled flows into products and those fees contributed to revenue beats. Management commentary noted a resilient U.S. economy, healthy consumers and low unemployment, but cautioned risks around inflation and geopolitics remain.

Yields across the curve were lower. 2-year and 10-year yields fell by the most in seven weeks, finishing 14 basis points and 15 basis points lower, respectively. 

In commodities, the price of oil (+2.0%) rose for the fourth week in a row as demand rises to deal with a colder than expected winter. Gold (+0.9%) is closing in on its best weekly streak since September amid continued central bank buying and geopolitical uncertainty.

As we close out the week, we use today’s note to give you our thoughts on what’s been happening at the longer end of the Treasury market.

Spotlight

Yields on 10-year U.S. Treasuries are over 100 basis points higher than their September lows – while the Federal Reserve has been lowering its target policy rate. That’s unusual. In the previous seven cutting cycles by the Federal Reserve going back to the 1980s, the yield on the 10-year Treasury was lower 100% of the time 100 days after the first rate cut.

The 10y Treasury yield is up 100bps since the first Fed cut. It's usually down.

What’s causing the atypical move in yields? The graph here uses a sign-restriction model to break down the factors driving the yield changes. While it may sound complex, it’s essentially a method to understand why yields are moving by examining how other market variables, like equity prices or inflation expectations, are behaving at the same time. (For example, if yields are rising alongside equities, it indicates a different scenario than if yields are rising while equities are falling.) This analysis suggests two main drivers: stronger growth expectations and heightened macroeconomic uncertainty.

Growth expectations and uncertainty are the primary drivers of recent rate increases

The U.S. has consistently outperformed growth expectations throughout 2024. Economists initially expected the economy to grow by 1.2% for the year. However, as we closed 2024, that estimate had more than doubled to 2.7%, with a significant portion of that adjustment occurring in Q4 alone. Robust growth exceeding expectations puts upward pressure on yields as the anticipated number of rate cuts by the Federal Reserve decreases.

Economic uncertainty is another major factor contributing to the upward pressure on yields. Questions remain about where Federal Reserve rates will land over the next year or two and what the new administration’s policies might mean for inflation and the Fed’s outlook. There is already approximately 150 basis points of variance among Federal Open Market Committee members regarding where rates should settle.

For what it’s worth, the most recent sell-off in bond yields doesn’t seem to reflect increased concerns about the U.S. deficit. The yield on longer-dated government bonds compared to interest rate swaps (which don’t face the same supply and demand dynamics) has remained stable since the middle of last year. This contrasts with the rising discount assigned to long-dated sovereign debt in the U.K., where investors have expressed more concern over the country’s ability to service its debt.

Discount for owning longer dated government bonds vs. interest rate swaps

We don’t see much upside for yields from here. If we assume the Federal Reserve is not going to reverse course and hike rates this cycle, which we feel strongly is not in the cards, we see limited room for yields to rise materially further from here.

12-month forward Treasury yield under different terminal rate assumptions

At present, we think rate hikes are off the table. The labor market hasn’t retightened and sectors sensitive to interest rates are still lagging. Increases in wages paid to employees peaked at 5.1% in 2022; since then, that figure has continued declining to 3.9%. In other words, employers believe they can offer smaller wage increases without risking employees leaving for other jobs. So far, that has been the case. The quits rate, which can be a proxy for labor force confidence (employees are less likely to quit their job if they don’t believe they can find another), has fallen to a five-year low. Moreover, interest rate-sensitive sectors have underperformed the broader market since the spring of 2023, when the Fed funds rate peaked above 5%. As we approach the rate that neither stimulates nor restricts economic growth, we would expect that performance gap to narrow.

So, we think that the Federal Reserve won’t hike rates, and thus rates are priced aggressively high for that scenario. What does that mean for portfolios? It means we are more comfortable adding duration at these levels than we have been for months. For U.S. taxpayers, moving from cash into municipal bonds – which have yields above their 25-year average – can provide tax-advantaged income and an opportunity for capital gains amid falling yields. For investors outside the U.S., European duration trades at elevated yields. And for those looking to take on extended credit risk, U.S. preferreds and direct lending offer near double digit yields.

Yields across the fixed income universe

For questions on how duration can best fit into your portfolio, reach out to your J.P. Morgan advisor.

All market and economic data as of 01/17/25 are sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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