Despite the Fed's decision to lower interest rates last week, Treasury yields are increasing. What's the explanation?

• Although the Fed reduced its short-term borrowing rate by half a percentage point, Treasury yields have been increasing, particularly at the long end of the curve.
• The Fed meeting is being priced in too much easing, and bond market professionals are attributing the move to this.
• The Fed's emphasis on supporting a softer labor market may indicate their willingness to accept slightly higher inflation than usual.

The Federal Reserve's larger-than-normal cut last week signaled that interest rates will significantly decrease in the future.

The Treasury market, though, hasn't been paying attention.

Although the Fed reduced its short-term borrowing rate by half a percentage point, Treasury yields have been increasing, especially at the long end of the curve.

Since the Federal Open Market Committee meeting of Sept. 17-18, the 10-year note yield, which serves as a benchmark for government bond yields, has increased by approximately 17 basis points, reversing a sharp decline that had occurred throughout September. One basis point equals 0.01%.

The trend in the bond market, which has been attributed to a simple makeup for markets pricing in too much easing before the Fed meeting, should be closely monitored as it could indicate something more ominous ahead.

The Fed's decision to keep interest rates low is due to its willingness to tolerate higher inflation, as well as concerns over the precarious U.S. fiscal situation and the potential that an onerous debt and deficit burden could raise long-term borrowing costs no matter what the Fed does.

"Jonathan Duensing, head of U.S. fixed income at Amundi US, stated that there was an element of people buying the rumor and selling the fact regarding the actual FOMC decision last week. He added that the market had already discounted a very aggressive easing cycle."

Despite Fed officials indicating smaller rate cuts at a meeting, the market had been pricing in larger cuts. Officials later penciled in another 50 basis points in reductions by the end of the year and another 100 by the end of 2025. In contrast, markets expect another 200 basis points of cuts in the same period, according to fed funds futures pricing as gauged by the CME Group's FedWatch tracker.

Yields on shorter-duration notes, such as the 1-year, have not seen significant changes, in contrast to the 10-year notes which have experienced an increase in yields.

This is where it gets tricky.

Watching the curve

The gap between 10- and 2-year notes has increased by approximately 12 basis points since the Fed meeting, which is referred to as a "bear steepener" in financial jargon. This occurs when longer-term yields rise at a faster rate, and is often associated with the bond market predicting higher inflation in the future.

The softening labor market is the reason why Fed officials are focusing more on supporting it, which implies that they are willing to accept a slight increase in inflation.

The "breakeven" inflation rate, which is the difference between standard Treasury and Treasury Inflation Protected Securities yields, reflects the sentiment that the Fed is raising interest rates to combat inflation. Specifically, the 5-year breakeven rate has increased by 8 basis points since the Fed meeting and by 20 basis points since Sept. 11.

"Robert Tipp, chief investment strategist at PGIM Fixed Income, stated that the Fed has shifted its stance because they are confident that inflation is under control, but they are seeing a rise in unemployment and a rate of job creation that is insufficient. The increase in long-duration yields is a clear indication that the market sees risks that inflation may be higher and the Fed may not take action to control it."

The Fed's favorite personal consumption expenditures price index is the closest gauge to the 2% inflation rate target, with a 2.5% rate in July and an expected 2.2% rate in August.

Policymakers are equally focused on preventing inflation from rising again, as it has in the past when the Fed eased too quickly.

The Fed is closely watched by markets, with a focus on the labor market and avoiding an unnecessary slowdown or recession caused by excessive tightening.

Possibility for big cuts ahead

"The Fed and Chair Powell have stated that they will be data-dependent in their decision-making process. Duensing believes that they are open to cutting another 50 basis points in response to the softening labor market, and are prepared to accommodate any necessary accommodations during the post-election meetings."

Then there's the debt and deficit issues.

The budget deficit's financing costs have surpassed $1 trillion for the first time due to higher borrowing costs. Although lower rates could ease the burden, long-term Treasury investors may be hesitant to invest in a fiscal situation where the deficit is approaching 7% of GDP, an unprecedented occurrence during U.S. economic expansions.

Fixed income investors are reducing their Treasury allocations due to market volatility, as stated by all the investors interviewed for this article.

They also think the Fed might not be done with big rate cuts.

"If the yield curve becomes steeper, it may signal an increase in recession risks, according to Tom Garretson, senior portfolio strategist for fixed income at RBC Wealth Management. Despite this, they may still decide to make another 50 basis point move this year. There is still a lingering fear that they are acting too late."