Mortgage rates also ticked up.

By Wolf Richter for WOLF STREET.

The Treasury yield curve is un-inverting piece by piece, but not in the way future homebuyers want: before and since the rate cut, shorter-term Treasury yields have fallen, driven by the Fed’s actual and expected rate cuts; but longer-term Treasury yields and mortgage rates have inched up.

As shorter-term yields drop while longer-term yields rise – or fall more slowly than shorter-term yields – the yield curve un-inverts step by step and eventually enters its normal state where all shorter-term yields are lower than longer-term yields.

But it still has a long way to go before it’s un-inverted all the way, to where shorter-term yields are lower than longer-term yields across the yield curve.

What we have now is a yield curve with still high but falling shorter-term yields, a sag in the middle with the low point at 3 years, and rising longer-term yields.

Mortgage rates roughly parallel the 10-year yield but at a higher level, and a daily measure of mortgage rates also ticked up since the rate cut on Wednesday.

The chart shows the “yield curve,” with Treasury yields across the maturity spectrum, from 1 month to 30 years, on three different dates:

• Friday, September 20 (red line)
• Tuesday, September 17, the day before the rate cut (blue line)
• July 23 (golden line).

Between July 23 and September 17, yields plunged across the yield curve in anticipation of lots of rate cuts from the Fed – thereby pricing in a bunch of future rate cuts:

• 3-month: -46 basis points
• 1-year: -86 basis points
• 2-year: -81 basis points
• 3-year: -81 basis points
• 5-year: -71 basis points
• 10-year: -60 basis points
• 30-year: -52 basis points

From September 17 to September 20, from the day before the rate cut to two days after the rate cut, reflected by the red line in the chart above, shorter-term yields fell further, but longer-term yields rose.

• 3-month: -20 basis points
• 1-year: -7 basis points
• 2-year: -4 basis points
• 3-year: +1 basis point
• 5-year: +4 basis points
• 10-year: +8 basis points
• 30-year: +11 basis points

Why have longer-term yields risen since the rate cut?

Trying to explain why something is happening in the financial markets is somewhat of an iffy affair. But we’re going to outline a couple of factors that play a role.

A bunch of rate cuts have already been priced in. Current shorter-term yields reflect expectations of future Fed policy rates within the term of the security. The act of pricing expectations of future rate cuts into current yields cause these yields to plunge.

For example, the 6-month yield will be most affected by expectations of what the Fed does over the next four to five months; the 2-year yield will be affected by expectations of what the Fed does over the next two years.

But this gets iffier for longer-term securities because other factors drive them, not just expectations of future short-term rates, including inflation expectations over their term.

Inflation concerns might be creeping back into the equation, now that the Fed is loosening monetary policy with a series of rate cuts in a decent economy with decent consumer spending growth, employment at record highs (though job creation slowed dramatically and that could turn into a problem), wage increases that are still substantial (3.8% year-over-year, 4.9% annualized in September), with still lots of liquidity sloshing around, loose financial conditions in many areas of the economy (CRE excepted), and with stock indices at precariously high levels. People with assets feel wealthy, and workers are still getting substantial pay increases, and that too drives spending, all of which is fertile ground for inflation to thrive.

Inflation has come down a lot — and that gives the Fed room to cut — but inflation is not a steady trend. It’s a zigzag movement, and CPI has accelerated month-to-month over the past two months, which may have just been another squiggle, or a change in direction. And no one knows what inflation will do in 2025 and 2026 when the Fed’s policy rates are lower. Investors who buy securities that have 10 years left to run struggle with these uncertainties and try to price them in somehow, which would cause longer-term yields to tick up.

Treasury yields and the Fed’s policy rates.

Short-term yields are pricing in the expected rate cuts during their term. A security with 3-months left to run will trade on expectations of rates largely over the next two months. The closer the security gets toward its maturity date, the less policy rates matter because on maturity date, the holder will get paid face value plus interest. And that’s the value of the security on that day.

So below are charts of some key yields in relationship to the Effective Federal Funds Rate (EFFR) which the Fed targets with its headline policy rate (blue in the charts).

The EFFR dropped 50 basis points the day after the Fed announced its 50-basis-point rate cut, from 5.33% on Wednesday to 4.83% on Thursday and didn’t change on Friday.

The 3-month yield dropped to 4.75% on Friday and is beginning to price in a rate cut in November. A December rate cut is outside its window and doesn’t impact it anymore:

The 6-month yield dropped to 4.43% on Friday, pricing in nearly 50 basis points in cuts within its window:

The 1-year yield dropped to 3.92% on Friday, pricing in about 100 basis points in cuts.

The 2-year yield dropped to 3.55% on Friday, pricing in another 120 basis points in cuts so far over the next year, and more cuts in the second year. Over the past 9 days, the yield has ticked down only 4 basis points, so roughly unchanged by the actual rate cut.

The arbitrage is that investors give up 120 basis points in current 3-month T-bill interest income, but as T-bill yields decline with rate cuts, the difference is going to shrink, and in about a year, that 3.55% interest income will be higher than T-bill yields will be then, and in the second year, will be substantially higher than T-bill yields will be then, so that over the 2-year term, the combined interest income will be slightly higher than the combined 3-month T-bill interest income over those two years – that’s the bet here.

The 10-year yield has risen 8 basis points since the rate cut, to 3.73% on Friday. It’s back where it had been 12 trading days ago. This is a long-term bet essentially on inflation and Fed policy rates. Investors are currently betting that inflation will average about 2% over the 10-year term. If those inflation expectations rise, the yield would follow.

Mortgage rates roughly parallel the 10-year yield but at a higher level. The spread between the average 30-year mortgage rate and the 10-year yield is currently 2.5 percentage points.

Over the past four decades, the spread has ranged from near 0 percentage points (briefly when the 10-year yield shot up in February 1980 and in May 1984) to over 4 percentage points several times in the 1980s.

Currently, the 2.5 percentage point spread is in the middle of that wide range but wider than average over the past 20 years.

During the years of QE, when the Fed bought MBS, the spread narrowed.

During QT, since the Fed started shedding MBS in late 2022, the spread has widened. The Fed said it would let the MBS run entirely off its balance sheet, so this is likely to continue for years even after QT ends. As the Fed steps away, market participants will have to be enticed to take its place, and this could mean that the spread will average wider than during the era of QE.

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