For the first time since 1989! The Federal Reserve has started to cut interest rates, but the 10-year U.S. Treasury yield has surged significantly

There is currently an intuitive contradiction in the U.S. bond market: the Federal Reserve has significantly cut interest rates, yet U.S. Treasury yields have risen. Since major central banks began to sharply lower benchmark interest rates in September, the yield on the 10-year U.S. Treasury has actually climbed more than 75 basis points, marking the largest increase in the first three months of a rate-cutting cycle since 1989.

Bond traders rarely suffer such significant losses during the Fed's easing cycles. Now, they are concerned that more of the same may occur in 2025. Last week, just as the Fed cut rates for the third consecutive time, the yield on the 10-year U.S. Treasury surged to a seven-month high, after Fed Chairman Jerome Powell and other policymakers hinted that they were prepared to significantly slow the pace of monetary easing next year.

Sean Simko, global head of fixed income portfolio management at SEI Investments Co., stated, "Treasuries are being repriced in line with the view that rates will be higher for a longer period and that the Fed's stance is becoming more hawkish." He expects this trend to continue, driven by rising long-term yields.

The rise in yields highlights the uniqueness of this economic and monetary cycle. Despite rising borrowing costs, a strong U.S. economy continues to keep inflation above the Fed's target, forcing traders to unwind bets on significant rate cuts and abandon hopes for a broad rally in bonds. After a year of volatility, traders now face another disappointing year, with overall U.S. Treasury investments barely breaking even.

The good news is that a popular strategy that has been effective in past easing cycles has regained momentum. This trade, known as "steepening the curve"—betting that the performance of short-term U.S. Treasuries sensitive to the Fed will outperform long-term U.S. Treasuries—has indeed been the case recently.

Pause in Rate Cuts

The outlook for the U.S. bond market will be challenging. Bond investors will not only have to contend with a Federal Reserve that may remain unchanged for some time, but also with the potential turmoil brought by the new government led by incoming President Trump. Trump has vowed to reshape the economy through policies ranging from trade to immigration, and many experts believe these policies could lead to inflation, thereby reducing the extent of Fed rate cuts.

Jack McIntyre, a portfolio manager at Brandywine Global Investment Management, stated, "The Fed has entered a new phase of monetary policy—a pause phase. The longer this situation lasts, the more likely the market will react similarly to both rate hikes and cuts. The uncertainty of policy will make the financial markets more turbulent in 2025."

Bloomberg strategist Alyce Andres noted, "The Fed's last meeting of the year has passed, and the outcome may support a steepening of the curve as the year ends. However, once the Trump administration takes office in January, this dynamic could stall due to uncertainty surrounding the government's new policies." Last week, Federal Reserve policymakers hinted that, amid ongoing inflation concerns, they are more cautious about continuing to lower borrowing costs, catching bond traders off guard. Fed officials expect to cut rates only twice by 25 basis points in 2025 after lowering rates by a full percentage point from a 20-year high. Of the 19 Fed officials, 15 believe there are upside risks to inflation, compared to only 3 in September.

Traders quickly adjusted their rate expectations. Interest rate swaps indicate that traders have not fully priced in the Fed's expectation of another rate cut before June next year. They bet on a total cut of about 37 basis points next year, below the median forecast of 50 basis points given by the Fed's dot plot. However, in the options market, pricing tends to favor a more moderate policy path.

The Bloomberg U.S. Treasury Benchmark Index fell for the second consecutive week, nearly erasing this year's gains, with long-term bonds leading the decline. Since the Fed began cutting rates in September, U.S. government bonds have dropped 3.6%. In contrast, during the first three months of the last six easing cycles, bonds had positive returns.

The recent decline in long-term bond prices has not attracted many bargain hunters. Although JPMorgan strategists led by Jay Barry recommend clients buy 2-year U.S. Treasuries, they stated they "see no need" to purchase longer-term Treasuries, citing a lack of key economic data in the coming weeks, light trading before year-end, and new supply. The U.S. Treasury plans to auction $183 billion in bonds in the coming days.

The current environment creates perfect conditions for a steepening strategy. The yield on the 10-year U.S. Treasury bond was once 25 basis points higher than the 2-year yield last week, marking the largest gap since 2022. Data released last Friday showed that the Fed's preferred inflation measure rose at its lowest level since May last month, narrowing this spread. But this trade remains a winner.

The logic behind this strategy is easy to understand. Investors are beginning to see the value of so-called short-term bonds, as the 4.3% yield on the 2-year U.S. Treasury is nearly equivalent to that of a 3-month Treasury bill. However, if the Fed cuts rates more than expected, the 2-year U.S. Treasury has an additional advantage, as its price may rise. Given the overvaluation of U.S. stocks, they also provide value from a cross-asset perspective Michael de Pass, the global head of interest rate trading at Citadel Securities, stated: "The market thinks bonds are cheap relative to stocks and views them as insurance against an economic slowdown. The question is, how much do you need to pay for that insurance? If you look at the front end of the curve right now, you don't have to pay much."

In contrast, in an environment of persistently high inflation and a still-strong economy, longer-term bonds struggle to attract buyers. Some investors are also cautious about Trump's policy platform, fearing it will not only stimulate economic growth and inflation but also exacerbate the already large budget deficit.

Michael Hunstad, the deputy chief investment officer at Northern Trust Asset Management, said: "When you start to think about the factors of a President Trump administration and spending, it will certainly push up those long-term yields." The firm manages $1.3 trillion in assets. Hunstad expressed optimism about inflation-linked bonds, considering them "relatively cheap insurance" against rising consumer prices