What's Eating Treasury Yields?

Overview:

• We've seen higher-priced treasury yields and accelerated selling momentum. We share potential explanations.
• With expected cuts to the Fed rate, several factors would be needed to continue the move higher in yields.
• Uncertainty may be ahead as Washington policy plays out, but economy and inflation may not accelerate so Fed rates could remain on hold through the first half of 2025.

Can You Take Me Higher?

Treasury yields have repriced sharply higher over the past month, with selling momentum accelerating since the start of the new year. Nominal 10-year rates have moved 60 basis points (bp) higher since early December 2024, with 5-year, 5-year real rates rising 51bp during the same period. The curve has also steepened significantly over this period, with 5 to 30-year rates up 11bp. There have been several explanations offered for the selloff, which we rank from most to least likely in our view:

Higher Growth Expectations

Our decomposition of the most recent move higher in 10-year rates suggests that rising real rates (which are consistent with growth) have been a key driver of the move higher. Investors have repeatedly upgraded their projections for growth in recent months — partly driven by the re-election of President Trump and partly due to much more resilient than expected economic growth in the U.S.

Repricing Fed expectations

The market has shifted expectations for Fed rate cuts significantly lower, currently pencilling in just 31bp of rate cuts in 2025 and a terminal rate of just above 4%. Since the lows in September 2024 the market's pricing for the terminal funds rate has risen by approximately 120bp, suggesting that investors expect higher rates for longer.

Inflation expectations

President Trump's re-election and ongoing uncertainty over the extent of new tariffs has also pushed inflation expectations higher. While the extent of new tariffs remains far from clear, we expect tariffs to leave inflation 1 percentage point (pp) higher by mid-2025 at approximately 3%. Treasury Inflation-Protected Securities breakeven rates (TIPS BEs) have widened by 19bp in the 10-year sector since early-December 2024, but with 2-year TIPS BEs remaining at just 2.85%, the market appears to be unclear about the extent of tariffs.

Market's Terminal Rate Pricing Has Rebounded Sharply

Increased supply expectations

The re-election of President Trump will bring a renewal of the 2017 Tax Cuts and Jobs Act (TCJA), with markets already expecting higher deficits to persist in the coming years. While 10-year term premium (TP) has risen by 60bp over the past, we believe TP is moving toward more normal levels consistent with longer-term averages. We look for 10-year TP to average approximately 50bp in the coming years.

Term Premium Has Risen Significantly, But Remains Low Historically

A lack of investor conviction is likely contributing to the move higher in interest rates as uncertainty remains elevated. Investors are waiting for additional clarity regarding the state of the U.S. economy and on President Trump's policy announcements, which we expect to come fast and furious after inauguration day.

What Would it Take for Rates to Move Even Higher?

While longer-dated yields have continued to edge higher, shorter-dated yields have struggled to keep pace. This is a function of Fed rate cut expectations, with the market continuing to pencil in a 4% terminal rate. We believe several factors would be needed to continue the move higher in yields:

Pencilling in rate hikes

With markets currently pencilling in 33bp of rate cuts in 2025, a further move higher in rates would likely require the market to price out the remaining cuts this year and start to prepare for rate hikes. Even though tariffs could push inflation higher in the near-term, we do not believe economic activity is re-accelerating, making a rate hike this year a relatively low-probability event.

Even more expansionary fiscal policy

The Treasury market is already pricing in elevated deficits in the coming years. However, if Congress passes bills that call for even higher deficits than anticipated, yields could be pressured even higher. Note that the slim Republican majority in the House will force them to use reconciliation procedures to pass bills. This will limit the ability to materially increase budget deficits as this process requires any changes to be deficit-neutral, preventing a sharp increase in deficits.

Tariff policies much worse than expected

If much larger tariffs end up being imposed, inflation expectations could rise significantly, pushing yields higher.

When Will Yields Come Back Down?

There are significant risks on the horizon and economic data in the near-term is likely to be subject to upside residual seasonality. However, we do not believe the U.S. economy or inflation are accelerating and view 10-year rates in the 4.50-5.00% area as a likely peak. That said, uncertainty over the path of monetary policy has kept many investors on the sidelines and could keep volatility elevated. This uncertainty could persist in the months ahead as investors stay cautious into President Trump's first 100 days in office, which promise a flurry of policy announcements.

We currently expect the Fed to keep rates on hold in H125, which should keep 10-year yields hovering in the 4.50-5.00% area. However, we look for the Fed to resume cuts in H225 as growth moderates. This should push yields lower during the year. Ten-year Treasuries now have positive carry and rolldown, so investors may view owning 10-year U.S. Treasury Bonds at current levels as an attractive value proposition and we expect 10-year yields to finish 2025 at 3.8%.