Bond yields search for direction as Fed waits on rate cuts

US government bond yields have climbed recently as the Federal Reserve tamped down interest rate cut expectations. Yet, the Treasury market's path forward may be murkier than it has been in years.

US Treasury yields, which move opposite prices, have largely risen since Fed Chairman Jerome Powell signaled that a rate cut in March was unlikely. The benchmark 10-year Treasury yield settled at 4.09% on Feb. 6, up 10 basis points from Jan. 31. The yield rose as much as 18 bps after the Fed's Jan. 31 meeting, while the two-year yield, which closely follows rate expectations, settled as much as 19 bps higher.

Inflation is cooling and nearing levels in line with the Fed's 2% target, yet labor demand continues to outpace supply, keeping the domestic jobs market relatively hot, and the US economy continues to expand, giving central bank officials little reason to lower rates. After significant volatility in the third quarter of 2023, followed by a bond market rally in the fourth quarter, Treasury yields could remain in search of a direction as the robust economy continues to fend off the impacts of an effective federal funds rate at its highest level in decades.

"We're going to spend the next few months not really doing much of anything, because we're still trying to collect further evidence of what's the path," Jack McIntyre, a portfolio manager at Brandywine Global, said in an interview. "I don't see the catalyst for a big move in yields one way or the other."

Fork in the road

Bond bulls, McIntyre said, need to see some evidence of weakness in the labor market, which would quicken the start of rate cuts, while bond bears need to see an uptick in inflation which would delay rate cuts. Neither looks likely in the near term, according to McIntyre.

With the Fed in a holding pattern and even a rate cut at the Fed's May meeting not guaranteed, yields may tread water for a bit.

While the 10-year yield is up year over year, it is down from its recent peak of 4.98% reached in October 2023. The S&P US Treasury Bond Index, a measure of the Treasury market's performance, is down about 1% so far this year, after climbing approximately 5% in the fourth quarter of 2023.

The 10-year yield could climb above 4.2% in the near term, but from there, the direction forward may depend on what happens next, from a clear policy shift from the Fed or another banking panic.

"It feels right to be back up here, threatening to take out that high, and making a path to the 4.25% area," said Padhraic Garvey, a managing director with ING, on the current 10-year yield. "The area between 4.25% and 4.5% is one where it will begin to feel like things have gone a bit too far, and one big catalyst can see us crashing back below 4%. We are just not at that tipping point yet."

Rates will continue to find equilibrium in coming weeks, but have likely peaked for this monetary policy cycle, said Gennadiy Goldberg, head of US rates strategy at TD Securities.

Still, yields may move a bit higher in the near term if the economy continues to outperform expectations. In addition, Goldberg said, the yield curve will likely steepen in the near term but may remain inverted until rate cuts commence.

The yield curve most recently inverted — with interest on short-dated bonds exceeding that of their longer-dated peers — in July 2022 and has remained that way since. The phenomenon typically precedes a recession, though one has yet to materialize.