The Federal Reserve finally cut interest rates. However, in the past few trading days, a key indicator of borrowing costs has been rising...

Since the Federal Reserve announced a 50 basis point rate cut last Wednesday, the yield on long-term US government bonds has been rising. The benchmark 10-year US Treasury yield closed at 3.743 last Friday, higher than the day before the rate cut by the Federal Reserve, which was 3.64%.

The 10-year yield on US Treasuries is known as the "global asset pricing anchor." Its rise serves as a reminder that the Federal Reserve cannot fully control domestic borrowing costs in the United States. Although the Fed manages overnight interbank lending rates between banks, these overnight borrowing costs are passed on to credit card debt and other types of floating rate loans. However, interest rates on other forms of debt, mainly bonds, are primarily influenced by fluctuations in US Treasury yields.

And this change depends on investors' expectations for the future direction of short-term interest rates set by the Federal Reserve, not the current level of rates...

Currently, the 10-year Treasury yield is indeed about 100 basis points lower than earlier this year, when the Fed's rate cut prospects seemed more uncertain. However, looking ahead, once the US economy remains stable, it is not certain that Treasury yields will continue to decline further, which may frustrate potential homebuyers and other borrowers hoping for larger interest rate declines.

John Madziyire, head of the Vanguard Group's Treasury department, said that his team is currently betting that Treasury yields may rise further and believes that the market's current forecast for the magnitude of rate cuts is still higher than the forecasts of most Fed officials themselves.

"If the Fed does not cut interest rates as aggressively as the market expects, the yield on 10-year U.S. Treasury bonds will actually rise," he said.

Why did the long-term bond yield rise instead of fall after the interest rate cut?

In terms of logic, the performance of the yield is still related to market expectations and the stance taken by the Fed. According to the CME Group's FedWatch Tool, bond market traders believe that the Fed's benchmark interest rate will decrease from the current near 5% to slightly below 3% by the end of next year. However, the Fed's dot plot only predicts that the benchmark interest rate at the end of next year will be between 3.25% and 3.5%.

In terms of long-term rate forecasts, the Fed's median estimate has even risen from 2.8% in the June dot plot to 2.9%.

It can be said that the rise in yields after the Fed's rate cut last week was particularly notable because the market has been debating whether the Fed should start its rate cut action by reducing the federal funds target rate by the traditional 25 basis points or a more aggressive 50 basis points. Those advocating for a larger rate cut generally have more concerns about the economic outlook. They believe that the Fed should take bolder measures to prevent further weakness in the labor market.

In fact, some investors believe that the Fed's choice of a 50 basis point rate cut as the starting pace for this round of interest rate cuts may even help push up long-term bond yields in the long run – because the Fed has chosen a larger rate cut from the beginning, indicating its willingness to fight to keep the economy away from a recession, which would almost certainly lead to a larger decline in long-term bond yields.

In addition to expectations about interest rate trends, the performance of the 10-year U.S. Treasury bond yield also depends to a certain extent on the term premium – that is, how much additional compensation investors require for holding longer-term government bonds instead of shorter-term government bonds.

Although the term premium has been declining in recent decades, many investors believe that once short-term rates stabilize, the yield on 10-year U.S. Treasury bonds should be about 100 basis points higher than short-term rates. One reason behind this is that investors expect the U.S. government to issue a large amount of bonds in the coming years to fund the increasing federal budget deficit. Some also mention the risk of inflation rising again.

Jeff Given, Senior Portfolio Manager at Manulife Investment Management, said, "Inflation has subsided but remains above the Federal Reserve's 2% target, so I believe investors holding long-term bonds will expect to be compensated for this."

Of course, some investors who are pessimistic about the economy are still betting that long bond yields may further decline.

Jamie Patton, Co-Head of Global Rates at TCW, believes that the lingering impact of the previous interest rate hikes by the Federal Reserve could lead to an economic recession, causing the 10-year Treasury yield to fall below 3% in the next six months.

She stated, "The Fed's rate cut this month will not impact the current economic situation - it will be helpful for the economy in the future, but in the next four to six months, the economy will still be affected by the lagging effects of tightening policies."

Editor/Rocky