Why did long-term U.S. Treasury rates rise despite the interest rate cuts? | Moomoo Research

Since the Federal Reserve announced interest rate cuts on September 18, the 10-year U.S. Treasury yield, often referred to as the "anchor of global asset pricing," actually rose instead of falling after the significant rate reduction, jumping from approximately 3.65% on September 17 to 3.78% on September 26. This led to a decline in the prices of long-term U.S. Treasury assets.

In contrast, the yields on shorter-term bonds, which are more sensitive to interest rate changes, fell, resulting in an expanded yield spread between the 2-year and 10-year Treasury yields. This caused the entire yield curve to steepen even more noticeably.

So why did long-term rates rise after the rate cut? How should investors choose when investing in U.S. Treasuries at this time?

The magnitude of the rate cut at the Federal Reserve's September meeting surprised the market, as a 50 basis point reduction at the outset is quite rare historically. Such a significant cut has typically only occurred during urgent economic or market situations, such as the tech bubble in January 2001, the financial crisis in September 2007, and the pandemic in March 2020.

Chart: Historical Rate Cut Cycles Since 1990—Magnitude and Context

Source: Public Data, Organized by Futu Securities

This round of rate cuts is still based on the assumption of a "soft landing." Although the labor market has cooled, there has not been a complete victory over inflation issues, and there are no clear signs of a recession. Therefore, this rate cut is more of a preventive measure. Powell also emphasized during the meeting that he has not seen any signs in the economy indicating that the likelihood of a recession is increasing.

1. Overall, long-term U.S. Treasury rates typically show a downward trend during rate cut cycles.

Since both the Federal Reserve's policy decisions and Treasury rates are influenced by economic fundamentals, both long-term and short-term Treasury rates tend to bottom out around the time of the last rate cut.

2. However, the performance of long-term and short-term U.S. Treasuries differs in the initial stages.

After the first rate cut of 25 basis points in 2019, long-term Treasury rates immediately followed suit and fell. In contrast, after the first rate cut of 50 basis points in March 2020, long-term Treasury rates initially experienced short-term volatility and an uptick, before declining again after March 18.

3. Rate cuts typically lead to an increase in the term spread of long-term Treasury bonds.

Historically, lowering interest rates tends to widen the term spread of long-term Treasury bonds, indicating that investors require higher additional yields to compensate for inflation and its uncertainties when holding long-term bonds.

However, the extent of the widening in the term spread is influenced by the magnitude of the rate cuts and other economic factors. For example, during the rate cut cycle from 1995 to 1998, the yield curve for U.S. Treasuries was relatively flat, with long-term bond yields declining similarly to short-term bond yields. In contrast, during the rate cut cycle from 2001 to 2003, the yield curve was steeper, resulting in a larger term spread by the end of the rate cuts.

Source: Public Data, Organized by Futu Securities

The factors affecting short-term and medium-to-long-term rates differ. Short-term rates are more sensitive to monetary policy and are directly influenced by the Federal Reserve's rate cuts, generally moving in line with changes in the Fed's policy rates. Medium-to-long-term rates typically exhibit a trend of oscillating downward, influenced by short-term rates.

However, in addition to policy rates, long-term rates are also affected by other factors such as economic growth rates, inflation levels, and market risk sentiment.

1. Anticipatory Positioning

After a prolonged low-interest-rate environment from 2009 to 2015, investors in U.S. long-term Treasury bonds seem to be positioning themselves ahead of time during the recent two rate cut cycles. This may be due to a shift in investor preference towards longer durations and higher coupon yields as the long low-rate environment comes to an end.

Since 2024, the yield on the 10-year U.S. Treasury bond decreased by 100 basis points within six months, briefly falling to 3.6%. According to the Fed's "dot plot" projections, there are expected to be two more rate cuts this year totaling 50 basis points, four cuts in 2025 totaling 100 basis points, and two cuts in 2026 totaling 50 basis points. Including the recent 50 basis point cut, the total expected reduction will reach 250 basis points, with a target range for the final rate between 2.75% and 3%.

Calculating from the 3.6% low, this suggests that some of the potential decline in Treasury yields has already been preemptively priced in, which may partly explain the recent rebound in the yield on the 10-year U.S. Treasury bonds.

2. Reinflation and Deficit Risks Increase Required Returns on Long-Term Bonds

Measured by the Consumer Price Index (CPI), the inflation rate in the U.S. has indeed sharply declined over the past two years. In August, the year-on-year increase in the U.S. CPI fell to 2.5%, significantly lower than the over 40-year high of 9.1% reached in June 2022.

The nominal yield on the 10-year Treasury can be decomposed into real yields and inflation expectations. The real yield can be gauged using the yield on 10-year Treasury Inflation-Protected Securities (TIPS), which has been declining since the rate cuts. This indicates that the recent rise in the nominal yield on 10-year Treasuries is primarily due to rising inflation expectations, with future inflation expectations over the next decade measured by TIPS showing a noticeable increase.

Real yields serve as indicators of economic growth. When bond investors start to anticipate an economic slowdown or recession, they may accept lower real yields due to increased uncertainty. The decline in real yields in September suggests that the economy is slowing. Meanwhile, the rise in inflation expectations also implies that a slowdown in economic growth may not necessarily be accompanied by a decline in inflation.

Source：FRED

Given that the current economic situation does not show signs of recession, there may not be a need for such significant rate cuts. A 50 basis point cut could be interpreted as "prematurely declaring" success in combating inflation. If the market perceives that the Federal Reserve is allowing inflation to rise to ensure full employment, then as inflation expectations become unanchored, yields may rise again.

Moreover, Powell has continuously emphasized that this round of 50 basis point cuts should not be taken as a new baseline for linear extrapolation. He also stressed that there is no fixed interest rate path; the Fed could accelerate, slow down, or even choose to pause rate cuts based on the circumstances of each meeting. This indicates that there is still uncertainty regarding future policy shifts from the Federal Reserve.

Additionally, the U.S. federal government's debt has surpassed the $35 trillion mark. Continuous fiscal deficits are causing the U.S. debt to grow increasingly high and loom overhead. Compared to the demand for short-term U.S. debt, the risks associated with long-term U.S. debt are higher, as the likelihood of a U.S. default next year is very low.

Short-term rates are more sensitive to rate cuts and have a relatively defined downside potential. The current yield on the 2-year Treasury bond is 3.56%, with the expected anchor corresponding to the end of this rate cut cycle around 3.0%. This leaves about 56 basis points of potential downside, indicating that short-term bonds still present investment opportunities.

Considering that this round of rate cuts is accompanied by fiscal expansion, sticky inflation, and potential overseas capital inflows due to continued rate hikes in Japan, the yield curve for U.S. Treasuries from 2 to 10 years is expected to be relatively steep, with long-term rates possibly experiencing some short-term adjustments.

However, under a baseline scenario of a soft landing, the recent adjustments in long-term U.S. Treasuries provide investors with certain entry opportunities. The current yield on the 10-year Treasury bond has rebounded to 3.78%, indicating a potential downside of 78 basis points based on the expected end of this rate cut cycle. Therefore, it may be appropriate to accumulate positions in relevant long-term bond ETFs at lower levels, and in the options market, investors could sell puts on corresponding long-term bond ETFs to earn premiums.