Will yields continue to climb if the Fed cuts further?

Longer-term bond yields usually fall when central banks are easing policy, at least in the US. But that’s clearly not happening at the moment, and we suspect that this will continue in the near term, or at least until the dust has settled on president-elect Trump’s economic policy. This means a clearing up of the uncertainty over tariffs, particularly the possibility of global tariffs that could have a meaningful impact on US inflation.

In the meantime, as the threats of more tariffs keep coming from Trump, we can expect yields to move higher with a 5% 10-year Treasury yield very much in sight. But what about the long haul—the next year or so? Will yields continue to climb if the Fed cuts further? We think the answer is ‘no’ for a couple of reasons.

First up, he does not expect inflationary pressure to rise to the extent that inflation expectations deanchor. While it has long been the Standard Bank’s view, right from when PCE inflation peaked at just over 7% in mid-2022, that the Fed would struggle to reduce inflation to the 2% target, it does not think that inflation will reaccelerate significantly. And besides, if this is wrong and inflation does rise materially again, the Fed will likely lift rates again, meaning that higher yields would be accompanied by higher policy rates.

Secondly, if inflation were to stay close to target and the Fed continued to ease, any significant long-term rise in bond yields would probably be associated with a loss of confidence in the US, most probably with fiscal probity. This is clearly possible. The US’s fiscal trajectory is unsustainable, as the Fed admits, and the US could endure a collapse in foreign investor confidence associated with the country’s huge external indebtedness. But while these possibilities exist, we do not think that they will happen. Hence, as the Fed slowly edges the fed funds target down to neutral over the next year, or so, which he puts at around 3.5%, so 10-year yields should fall back to 4%, or below, again.

The US is vulnerable to a collapse in foreign confidence because the country has huge external debt. However, the global dominance of the US dollar and the safe-asset allure of treasuries afford the US a significant safety cushion. For instance, some estimates suggest that the US could have a debt/GDP ratio of 20% points more than its peers and not suffer undue financial consequences on account of the country’s so-called exorbitant privilege. The flipside of this is that other countries that have similarly large, or even larger, external indebtedness than the US can face aggressive runs on their bond markets.

Back in September 2022, an injudicious mini-budget caused confidence in gilts to ebb away dramatically, although this reflected largely sales by UK institutions, not foreign sales. The very recent slide in gilt yields reflects different factors from those in 2022, as we discussed over the page. Nonetheless, we cannot ignore the risk that a slide in gilts, which may have its origins in US treasuries, could turn into a rout. With sterling at risk as well, it is easy to understand why the market has factored base rate cuts out of its expectations at a rate of knots. In a worst-case scenario, the BoE could be forced to hike the rate again to restore confidence. But we do not think it will come to that.

Like treasuries, we think that gilt yields will move down in the long haul, and we do believe that the Bank of England will be able to cut base rates far more than the 1-2 cuts currently priced into the market through the rest of 2025. But is it right to stand in front of this gilt market steamroller and predict that yields will move down from here? We do not think so. We are more optimistic about yields falling back in the euro zone, which is, in part, due to the fact that we do not see any significant pause in the course of ECB easing, and the large external surplus the euro zone has with the rest of the world offers the bond market a degree of support.

Quite clearly, if Treasury yields rise further, it will drag eurozone bonds with it, but EGBs should lag behind, and, once the bond market turns, the fall in EGB yields should be more marked. For instance, we believe that 10-year bund yields will be up to 100 bps lower at the end of the year than they are today compared to just 50 bps lower in the US.