The steepening trend of the US Treasury yield curve is facing challenges. How will the Federal Reserve respond?

Recently, the US bond market has experienced a wave of rapid buying, which has caused the yield of 2, 10, and 30-year US bonds to fall to varying degrees. Combined with the repeated lower-than-expected US labor force data and inflation concerns caused by the trade war, the market has been popular in trading stagflation in the United States, that is, long-term US Treasury bonds and short-term Treasury bonds to gain profits (because short-term bond yields are sensitive to interest rates, while long-term Treasury yields are sensitive to inflation). Although Treasury yields have declined, the steepening of the yield curve has not changed. However, the most mainstream trading strategy in the US bond market is being tested recently, and it has laid the groundwork for the Federal Reserve's interest rate decision to exceed expectations.

The U.S. Treasury market, which is as high as $29 trillion, is experiencing a fierce tug of war

In this market, two types of one-way investors are already in a tug-of-war situation: those who are worried that the labor market will crack, or prompt the Federal Reserve to cut interest rates sharply, and those who are worried that the Federal Reserve's anti-inflation process has not yet ended. They sell Treasuries.

Early last week, this benchmark yield briefly fell below the key psychological level of 4%, while the recent recovery of the 10-year US Treasury yield to more than 4% just confirms the above-mentioned tug of war.

On Monday afternoon, the 10-year U.S. Treasury yield was 4.034%, a data that shows that investors are still hesitant to allocate long-term U.S. Treasuries in the face of relatively low yields this year.

Investors remain cautious until the Federal Reserve's two-day policy meeting ends in the early hours of Thursday, when Jerome Powell, chairperson, is expected to announce a 25 basis point cut in short-term interest rates and an updated economic outlook.

Gennady Goldberg, head of US interest rate strategy at TD Securities, said: "A lot of investors are not willing to chase up and sell down - that is, they are not willing to follow the trend and increase their holdings of bonds when yields are down." Bond prices and yields are inversely correlated.

Despite the increased volatility in the US bond market this year, US bond yields have generally been on a downward trend compared with six months ago. The yield on the two-year US Treasury has fallen much more than the yield on the 10-year US Treasury. But this is not the only trading line worth watching in the US bond market.

Steep trading strategy like a duck to water

One of the most mainstream trading strategies among bond fund managers is to bet that the yield curve "steepens" - that is, the spread between short-end and long-end Treasury yields widens.

The strategy has paid off recently: A few weeks ago, the spread between 10-year and 2-year Treasury yields hit 65 basis points, the second highest since January 2022 and only down from a brief spike to 67 basis points during the tariff shock in April.

Kent Engelke, chief economic strategist at CapitolSecuritiesManagement, is part of the "steepening yield curve" camp.

"I am convinced that the yield curve will steepen based on a number of factors," said Mr. Engelke, who pointed to continued upward inflation, the huge US fiscal deficit and the Trump administration's assault on the Fed's independence as core drivers.

Steep trading strategies carry risks, and the Federal Reserve's interest rate decision could be reversed

Royal Bank of Canada strategists had accurately anticipated in early September that investors betting on a steepening US Treasury yield curve, which has eased slightly in recent days, could face a "pain trade" ahead of the Fed's decision.

Simon Dangoor, head of fixed-income macro strategy at Goldman Sachs GoldmanSachsAssetManagement, believes that the Fed may launch a series of "adjustment rate cuts," but it will not be forced to initiate emergency measures due to the significant increase in recession risk.

Specifically, he expects the US economy to achieve a soft landing despite recent cracks in the labour market. "The current environment is relatively favourable for investors betting on a steepening yield curve," Mr. Dangur said, but he also believes the follow-up "has become more complicated".

The S & P 500 and Nasdaq Composite Index hit record highs on Monday, buoyed by expectations that the Federal Reserve could cut interest rates while boosting stocks and helping the economy reach a soft landing.

Amar Reganti, fixed-income strategist at Hartford Funds, said the Fed appeared to be focusing more on cracks in the labour market than on inflationary pressures, but he also said it was too early to judge the likely impact of tariffs on inflation.

"I think the mistake in the market is to assume that the cost of tariffs will be transmitted to the price side all at once," Mr. Reganti said of the tariff cost issue. "We always think it's a non-linear process - it may be transmitted quickly, it may be transmitted slowly, or it may not be transmitted at all."

From the perspective of the yield curve, the above proposition has been verified. Since the 10-year Treasury yield = the Fed's base rate + inflation expectations, the US 10-year yield and 2-year yield are falling rapidly, indicating that the market is digesting the Fed's interest rate cut expectations or that the market is suppressing the Fed's inevitable interest rate cut.

However, the spread between the 2 and 10-year Treasury yields in the United States is becoming steeper, and the rate of decline in the 10-year Treasury yield is slowing rapidly, indicating that traders' concerns about inflation require the 10-year Treasury to provide higher yields.

Due to the fact that the US 10-year Treasury yield is sensitive to inflation, and the US PPI and CPI data do not provide clues that inflation will continue to rise, the effect of superimposing US tariffs on inflation transmission is unknown.

Based on the above logic, we can deduce as follows: the core of the current support for the steepening of the yield curve - that is, high inflation expectations - actually lacks solid data support. In the future, once inflation expectations fall back, even if it only returns to normal levels, it may trigger the flattening of the yield curve of government bonds. The transmission path is that the cooling of inflation expectations will directly depress the yield of the more inflation-sensitive 10-year government bond, causing it to decline faster, which will narrow the spread with the 2-year government bond.

In particular, traders need to be reminded that this flattening risk has the potential to intensify: if inflation data not only fails to rise, but also falls below expectations, it will hit market sentiment sharply, causing the 10-year yield to fall sharply as inflation expectations collapse, and the curve will flatten much faster and more than expected.

In addition, there is another narrative in the market: the recent rapid decline in the 10-year yield may itself be the market trading "cooling inflation expectations". If subsequent data (such as CPI) continue to prove that tariffs are not effectively driving up inflation, then even if the Federal Reserve chooses not to cut interest rates for the time being in order to maintain its independence, the 10-year yield may be driven lower by easing expectations alone. In this case, the flattening of the yield curve will be the result of spontaneous market trading, not Fed policy.

In short, the movement of the 10-year yield provides a "buffer" for the Fed. The market's spontaneous "easing trade" (reflected in the decline in long-end interest rates) has partly replaced the urgency of the Fed's rate cut. This buys time for Powell, who can choose to wait for more solid data before making a decision, thus avoiding being "kidnapped" by market expectations and better safeguarding the Fed's policy independence.