Tariff Shock Reverberates in the Bond Market
Longer-term Treasury yields have climbed, keeping borrowing costs elevated, even as short-term yields have dropped
By Sam Goldfarb, The Wall Street Journal, May 11, 2025
Key Points
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Treasury yields are diverging as longer-term yields rise.
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Uncertainty about inflation is driving up yields on longer-term Treasurys, while short-term yields fall on rate-cut bets.
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The widening gap between short- and long-term Treasury yields could complicate the Fed’s ability to spur growth with rate cuts…
Typically, Treasury yields are heavily influenced by what investors expect short-term rates set by the Fed will average over the life of a bond. But longer-term yields—which play a major role in determining borrowing costs across the economy—have become less connected to that outlook, potentially making it harder for the Fed to spur growth with rate cuts. …
Investors are demanding more yield for the risk of holding Treasurys for a longer period — a form of additional compensation known as term premium…
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When the Treasury yield curve is inverted, as it was between 2023 and late 2024, the term premium is negative. It’s more normal for the term premium to be positive since investors require compensation for inflation plus the uncertainty of tying up money for such a long period of time.
The term premium has finally become positive but it’s far less than the historical norm.
The markets have a very short-term memory so they aren’t looking back at the historical norm. Any increase in long-term borrowing costs, even a small one, will impact the enormous government deficit.
The Federal Reserve controls the short-term fed funds rate. The CME’s Fedwatch tool shows a 50-50 chance that the Fed will cut 0.25% in July and about 90% by September. But the Fed is in no hurry to cut so that may be front-running as we have seen so often before.
Barring crisis conditions (QE) the Fed doesn’t directly influence long-term bond yields. The markets control the longer term yields.
The Chicago Fed’s National Financial Conditions Index (NFCI), which provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems, shows that recently tightening conditions may have peaked.
All markets are gradually recovering from the shock of President Trump’s so-called “Liberation Day” but they are all below their 2024 trends.
The markets are optimistic. The Fear & Greed Index is in Greed. The trade is risk-on as stocks and junk bonds are rising faster than the 10 year Treasury price.
The markets bounced back on hope that the tariff situation can be managed. But the outcome is highly uncertain. The ramifications of higher prices, lower trade and probable stagflation will take a while to develop.
The Atlanta Fed’s GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2025 was 2.3 percent on May 8.
The METAR for next week is sunny. But the METAR is a short-term weather report. The longer-term is likely to be more problematic.
Wendy
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html