U.S. Treasury prices rebounded, and the market chose to "temporarily believe" Waller

Author: Li Jia, Wall Street Journal

Wash held firm against Trump's pressure for interest rate cuts, using rate hikes to demonstrate the Federal Reserve's determination to control inflation—this time, the market chose to believe.

After three years, the Federal Reserve restarted interest rate hikes, temporarily easing tensions in the U.S. Treasury market. On Thursday, the yield on the U.S. 10-year Treasury bond fell to 4.97%, ending a consecutive eight-day rise; the two-year yield also dropped 3 basis points to 4.70%, retreating from the 2024 high reached on Wednesday.

This rate hike had already been fully priced in by the market; what truly kept investors on edge was whether the Federal Reserve would remain inactive. If the rate hike fails to materialize, doubts about the Federal Reserve's determination to control inflation may resurface, further impacting the bond market. With the rate hike now in place, this tail risk has temporarily receded, leading to a decline in Treasury yields.

Meanwhile, the global bond market still faces pressure. This week, the average yield on global government bonds rose to its highest level since 2007, with the situation in the Middle East pushing oil prices higher, further strengthening inflation expectations. The pressure on the bond market has extended beyond U.S. monetary policy to broader factors such as inflation and fiscal supply.

Rate Hike Implemented, Market Begins to Believe in Wash's Hawkish Path

"The Federal Reserve has no choice but to give the market a rate hike, or it will face a larger bond sell-off." Byron Anderson, head of fixed income at Laffer Tengler Investments, stated.

Olumide Owolabi, a senior portfolio manager at Neuberger Berman, believes that the current pricing of rate hikes in the market has exceeded the Federal Reserve's own forecasts, and interest rates are expected to stabilize at high levels. "We expect interest rates to stabilize at current high levels and will selectively increase duration allocation."

Wash's statements have reinforced the market's expectations for further tightening of policies. The Federal Reserve's preferred inflation indicator, PCE, recorded 3.7% in July, close to the highest level since 2023, significantly above the long-term target of 2%. Wash indicated that summer inflation data has not shown substantial improvement in underlying inflation trends.

The Federal Reserve's dot plot shows that the median forecast among officials still anticipates one more rate hike this year; the interest rate swap market implies expectations for three more cumulative rate hikes by mid-2027. Although the implementation of the rate hike has alleviated short-term selling pressure, the market's judgment that rates will remain high has not changed.

Long-End Pressure Not Resolved, 30-Year U.S. Treasuries Face Further Upside Risk

While short-end rates are being repriced, long-end U.S. Treasuries must also contend with the combined effects of inflation, fiscal deficits, and government bond supply. Guneet Dhingra, head of U.S. interest rate strategy at BNP Paribas, recommends shorting 30-year Treasuries, targeting a yield of 5.6%, reasoning that the Federal Reserve will bring rates back into a restrictive range.

Hebe Chen, an analyst at Vantage Global Prime, stated that the impact of this rate hike on the bond market may not be a brief shock. The short end needs to reaccount for the possibility of further tightening, while the long end is simultaneously constrained by inflation, large-scale bond issuance, and fiscal risks.

Therefore, the decline in U.S. Treasury yields on Thursday appears more like a short-term correction following the implementation of the rate hike, rather than a complete alleviation of long-end pressure. As long as inflation remains high and fiscal financing needs persist, long-end yields may still face upward pressure.