Bond market reacts to inflation expectations and supply of new bonds, not the Fed’s policy rates.

By Wolf Richter for WOLF STREET.

The 10-year Treasury yield closed at 4.14% on Friday, after having dropped briefly below 4.0% on September 11 (closing at 4.01%). On Wednesday last week, during an algo-driven moment, it also dropped to 4.0%, from 4.05%, then jumped right back to 4.05%, and ended the day at 4.06%, after the Fed had released its statement of a 25-basis-point cut. It then continued to rise to end the week at 4.14%.

The Effective Federal Funds Rate (EFFR), which the Fed targets with its five monetary policy rates, dropped by 25 basis points to 4.08% after the cut, from 4.33% before the cut (blue in the chart). The EFFR is now once again below the 10-year Treasury yield.

This phenomenon of rate cuts causing long-term yields to rise is rare – but we had it before, namely a year ago, when the Fed cut by 50 basis points at its September meeting, and the bond market got spooked by the sight of a lax Fed amid accelerating inflation. By the end of the year, the Fed had cut by 100 basis points, and the 10-year Treasury yield had jumped by 100 basis points, and the Fed, having learned a lesson, put further rate cuts on ice, and started talking hawkish, which succeeded in coaxing long-term yields – including mortgage rates – back down. But then the Fed went at it again with another rate cut.

This time, the Fed was more careful, less dovish: It cut only by 25 basis points, and Powell was less dovish than the statement even, and so the bond market’s reaction to the rate cut might have been a little less pronounced than it was a year ago.

But if the next few batches of inflation data continue along the worsening inflation trends, it could still spook the bond market further and lead to higher long-term yields despite the rate cuts.

The 30-year Treasury yield ended the week at 4.75%, up by 10 basis points from the day before the Fed’s rate cut.

The upward trend of the 30-year yield started in August 2020 at 1.25% (after trading briefly at 1.0% in March 2020). By the end of 2021, it was at 2.0%, and by the end of 2023, just under 4%. It went over 5% in October 2023 and a few times briefly since then.

Note the divergence of the 30-year Treasury yield and the EFFR, as the 30-year yield reacts to bond-market issues, such as expectations of future inflation and supply of new bonds that have to be absorbed, rather than the Fed’s policy rates.

But the 6-month Treasury yield reacts to expectations of the Fed’s policy rates over the next two months or so and is a good indicator where the short end of the bond market thinks the Fed’s policy rates will be within its window. It currently expects another 25-basis-point cut over the next two months.

So the 30-year Treasury yield – which reacts to the bond-market issues of inflation expectations, supply of new bonds, etc. – has diverged dramatically from the six-month Treasury yield, which reacts to expectations of the Fed’s policy rates over the next two months.

That part of the yield curve – the 30-year yield and the 6-month yield – inverted in mid-2022 as the Fed was pushing up policy rates in 75-basis-point increments, and the 6-month yield stayed ahead of them, while the 30-year yield was only slowly disabusing itself from the Fed’s concept that this inflation was transitory.

But as the Fed was cutting rates in late 2024, the 6-month yield stayed ahead of those rate cuts and fell, while the 30-year yield surged, driven by an edgy bond market, and that part of the yield curve un-inverted in October 2024 and has steepened since then.

Yield curve steepened at longer end after rate cut.

The chart below shows the yield curve of Treasury yields across the maturity spectrum, from 1 month to 30 years, on three key dates:

• Red: Friday, September 19, 2025.
• Blue: September 16, 2025, just before the Fed’s rate cut.
• Gold: July 25, 2025, just before weak labor market data overpowered hot inflation data.

The 1-month yield is boxed in by the Fed’s five policy rates (from 4.0% to 4.25%) and closely tracks the EFFR.

The shorter-term yields are moved by expectations of the Fed’s policy rates, and they’re expecting more rate cuts this year and next year.

But the further yields go out on the yield curve, the more they’re influenced by inflation fears and supply concerns, with the 30-year yield being the ultimate test of them.

So from the two-year yield on out, yields have risen since just before the rate cut by:

• 2-year: +7 basis points
• 3-year: +9 basis points
• 5-year: +10 basis points
• 7-year: +11 basis points
• 10-year: +10 basis points
• 30-year: +10 basis points

Cutting policy rates during inflationary times is a delicate operation that has the potential of turning the bond market into a scourge. If inflation settles down in the 2% range, no problem. But if it continues to accelerate as it has done over the past few months, with services inflation being the big driver, and goods inflation chiming in and making it worse, then the bond market’s reaction to a lackadaisical Fed could get ugly.

Mortgage rates have jumped more than Treasury yields: the daily measure of the average 30-year fixed mortgage rate by Mortgage News Daily has jumped by 22 basis points since just before the rate cut, from 6.13% on September 16 to 6.35% on Friday.

This is about double the increase of the 10-year Treasury yield over the same period, a replay of what happened a year ago after the Fed’s big rate cut.

These mortgage rates of 6% to 7% are now only a big deal because home prices exploded by 50% and more during the two years between mid-2020 and mid-2022. This home-price explosion was caused by the Fed’s reckless monetary policy that created 30-year fixed mortgage rates that were far below the raging inflation rates – better than free money, and when money is free, prices don’t matter.

But that’s a bubble-pricing problem now that should have never occurred, not a rate problem. The rates are fine. They’re historically at the low end of the normal range. The 5% and below mortgage rates were a creature of massive QE during the Financial Crisis and after, when the Fed loaded up on trillions of dollars of Treasury securities and MBS to push down long-term rates. But the Fed has been doing the opposite since the second half of 2022 and has shed $2.4 trillion of those securities as QT continues.

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