Bond Traders Defy the Fed and Spark Heated Debate on Wall Street

(Bloomberg) — The bond market’s reaction to the Federal Reserve’s interest-rate cuts has been highly unusual. On that point, at least, there is broad agreement on Wall Street. By some measures, a disconnect like this, with Treasury yields climbing as the central bank lowers rates, hasn’t been seen since the 1990s.

What exactly it means, though, is another matter. Opinions are all over the place, from the bullish (a sign of confidence that recession will be averted) to the more neutral (a return to pre-2008 market norms) to the favorite culprit of the so-called bond vigilantes (investors are losing confidence the US will ever rein in the constantly swelling national debt).

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But one thing is clear: the bond market isn’t buying President Donald Trump’s idea that faster rate cuts will send bond yields sliding down and, in turn, slash the rates on mortgages, credit cards and other types of loans.

With Trump soon able to replace Chair Jerome Powell with his own nominee, on top of everything else is the risk of the Fed squandering its credibility by caving to political pressure to ease policy more aggressively — which could backfire by fanning already elevated inflation and pushing yields higher.

“Trump 2.0 is all about getting long-term yields down,” Steven Barrow, head of G10 strategy at Standard Bank in London. “Putting a political figure at the Fed will not get bond yields down.”

The Fed started pulling its benchmark rate down from a more than two-decade high in September 2024 and has since cut it by 1.5 percentage points to a range of 3.75% to 4%. Traders see another quarter point cut after the next meeting on Wednesday as virtually assured and are pricing in two more such moves next year, which would bring its rate to 3%.

Yet, key Treasury yields — which serve as the main baseline for the borrowing costs paid by American consumers and corporations — haven’t come down at all. Ten-year yields have risen nearly half a percentage point to 4.1% since the Fed started easing policy and 30-year yields are up over 0.8 percentage point.

Normally, when the Fed moves short-term policy rates up and down, long-term bond yields tend to follow. Even in the only two easing cycles outside of recessions over the past four decades – in 1995 and 1998, when the Fed cut only 75 basis points each time — the 10-year yield dropped outright or rose less than they have during the current episode.

Jay Barry, head of global rates strategy at JPMorgan Chase & Co., sees two factors behind it. The scale of the Fed’s hikes during the post-pandemic inflation surge was so steep that markets started pricing-in the Fed’s about-face well before it started, with 10-year yields peaking in late 2023. That blunted the impact once it began.

Moreover, by slashing interest rates even when inflation remains elevated, he said, the Fed is lessening the risk of a recession, limiting the scope for yields to fall.

“The Fed is looking to sustain this expansion, not end it,” said Barry. “That’s why rates have not moved aggressively lower.”

Others see a less benign interpretation in the so-called term premium, a measure of the extra yield investors demand in return for holding long-term bonds.

That compensates them for potential risks down the line — like elevated inflation or an unsustainable federal debt load. And that premium has risen nearly a full percentage point since the rate-cut cycle began, according to the New York Fed estimates.

For Jim Bianco, president of Bianco Research, it’s a signal that bond traders are worried that the Fed is cutting rates even as inflation remains stubbornly above its 2% target and the economy keeps defying recession fears.

“The market is really concerned about the policy,” said Bianco. “The concern is that the Fed has gone too far.”

If the Fed continues to cut rates, the mortgage rates will go “vertical,” he added.

There’s also angst that Trump — after breaking sharply from his predecessor’s deference to the Fed’s independence — will succeed in pressuring policymakers to continue cutting rates. Kevin Hassett, the White House National Economic Council Director and a Trump loyalist, is the betting market’s favorite to succeed Powell when his term ends in May.

What Bloomberg Strategists say…

If rate cuts increase the likelihood of stronger growth, they won’t be met with lower yields. We’ll end up with higher ones. In many respects, this is because we’re going back to a normal interest rate regime, where 2% real returns and a 2% Fed inflation target produces a 4% floor for long-term yields. Add in stronger growth and the numbers go higher from there.

—Ed Harrison, Bloomberg Markets Live strategist. Read more here.

So far, though, the broader bond market has remained relatively stable, with 10-year yields hovering not far from 4% over the past few months. And breakeven rates — a main gauge of the bond market’s inflation expectations — have been stable as well, indicating that fears of a Fed-fueled inflation surge down the line may be overstated.

Robert Tipp, chief investment strategist fixed income at PGIM, said it looks more than anything like a return to the normal levels seen before the Global Financial Crisis, which ushered in a long era of unusually low interest rates that abruptly ended after the pandemic.

“We’re back at the normal level of rates world,” he said.

Standard Bank’s Barrow said the Fed’s lack of control over the longer-term yields reminds him of a similar — if opposite — bind the central bank faced in the mid-2000s that became known as the Greenspan conundrum.

At that time, Chair Alan Greenspan was puzzled why the long-term yields remained low even as he jacked up the short-term policy rate. Greenspan’s successor Ben Bernanke later attributed the conundrum to too much savings from overseas flooding into Treasuries.

Today, Barrow said, that dynamic is reversed as governments around major economies are borrowing too much. That saving glut, in other words, has turned into a bond-supply glut that’s keeping consistently upward pressure on yields.

“It’s possibly a structural move that bond yields are not going down,” Barrow said. “At the end of the day, central banks don’t determine the long term rate.”

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