According to the Securities Times app, China Galaxy Securities released a research report stating that since the Federal Reserve initiated this round of interest rate cuts on September 18 by 50 basis points, the 10-year US Treasury yield has increased by about 13%, rising from around 3.7% on the rate cut day to above 4.2%, an increase of nearly 50 basis points, contradicting short-term and historical experience. Currently, the central range of the 10-year US Treasury yield is still roughly around 3.7%-4.3%, with 4.3% already considered the upper bound under the assessment of natural interest rates and term premium. Although in the short term, in the case of economic data exceeding expectations, the Federal Reserve being more cautious in the rate cut magnitude, and the continued expansion of the fiscal deficit, it is not ruled out that the long-term US Treasury yield may continue to rise, but the possibility of reappearing configuration value after exceeding 4.3% may be evident.

China Galaxy Securities' main points are as follows:

Since the Federal Reserve initiated this round of interest rate cuts on September 18 by 50 basis points, the 10-year US Treasury yield has increased by about 13%, rising from around 3.7% on the rate cut day to above 4.2%, an increase of nearly 50 basis points, contradicting short-term and historical experience. Will the trend of the 10-year US Treasury yield after this rate cut be different?

Why did the 10-year US Treasury yield increase after the rate cut?

Resilient non-manufacturing PMI data in September, better-than-expected labor market, CPI, and retail sales data have largely dispelled concerns about short-term recession in the U.S. and instead sparked concerns about 'no landing + re-inflation'.

From the details of the September FOMC minutes and comments from Federal Reserve officials, the 50-basis-point rate cut in September was not a strong consensus. In light of subsequent strong economic data, some voting members indicated if data exceeds expectations within 2024, a rate cut might be skipped, while still expressing concerns about the risk of inflation rebounding.

At the beginning of October, the election situation once again turned in favor of Trump, providing momentum and room for imagination for the US dollar index and US bond yields to continue to rise after a rebound.

Why is the market worried about the continuous rise in long-term US bond yields?

The 10-year US bond yield can be simply decomposed into the 'natural rate + long-term inflation center (expectation) + term premium'. With the support of unconventional monetary policy, some investors believe that the natural interest rate level is likely to rise above 1.5%, while the current core inflation center is probably around 2.5%-3.0%, which has already placed the 10-year treasury yield between 4.0%-4.5%. And if on this basis, the term premium rises, then a 5.0% 10-year treasury yield is not far off.

Both parties in the United States are heading in the same direction when it comes to expanding the fiscal deficit, which means more government bond supply. Currently, short-term US debt (within 1 year) accounts for about 20% of outstanding marketable securities. If the large fiscal deficit continues in the future and this ratio is maintained, then the supply of medium and long-term bonds (coupon) will inevitably increase, which is also unfavorable for the price of 10-year treasuries during the quantitative tightening (QT) still in progress.

From a demand perspective, in the near termMutual fundsand the marginal decline in the value of US bonds held by banks, overnight reverse repurchase accounts are struggling to continue providing liquidity support, while the Fed continues to shrink its balance sheet; if supply further increases, demand growth may struggle to match, leading to a rise in long-term yields. At the same time, looking at the MOVE index used by US banks to measure bond market volatility, the volatility in the bond market seems to align overall with yields since this current rate hike cycle began; recent volatility due to issues such as elections and market liquidity may lead to further increases in long-term US bond yields.

There is no need to overthink the first reason for the continued rise in US bond yields.

The natural interest rate of 4.0%-4.5% seems to have prematurely priced in the fiscal expansion and the significant rebound of inflation center along with the expected range of positive term premium, which belongs to a conceptual numerical value. The approximate range calculated by the New York Fed is between 0.7% and 1.3%, assuming a natural interest rate of 1.5% or higher implies stronger medium- to long-term inflation and growth center, but there is currently no particularly strong evidence to support this assumption. The Fed's September economic outlook evaluates the neutral interest rate at around 3%, corresponding to a natural interest rate level of around 1% under the achievement of a 2% inflation target.

In terms of term premium, since the implementation of quantitative easing after the financial crisis, although term premiums have fluctuated, they have generally shown a downward trend. This essentially reflects the market's increased confidence in US Treasury security following the Fed's market intervention after expanding its balance sheet. The upward slope of total debt growth since the global financial crisis has not affected the decrease in term premium.

Given the background of US monetary policy aligning with fiscal policy, it is normal for the Fed's balance sheet to continue expanding in line with the economy and deficits. The Fed has shown a firm determination to expand its balance sheet when necessary to absorb government debt during multiple crises. With this unchanged core logic, there is limited room for the term premium to rise in the medium to long term. The reasonable range for the 10-year Treasury yield remains around 1.3% natural interest rate + approximately 2.5% core inflation + 0%-0.5% term premium, i.e., around 3.7%-4.3%, and the current market pricing is already quite sufficient.

There is no need to overthink the second reason for the continuous rise in US Treasury yields.

While it is highly probable that the US fiscal expansion will increase the issuance of government bonds, if medium- to long-term interest rates are significantly higher than short-term rates, the Treasury Department still has the incentive to further increase the proportion of short-term debt in the outstanding debt. For example, when there was a rapid decline in the 10-year Treasury yield after mid-October 2023, the Treasury Department increased the percentage of short-term debt (from 16.78% to nearly 20%), which had an impact.

If the US fiscal deficit further expands significantly in 2025, and the market does indeed push up long-term bond yields through higher term premiums as it did in the second and third quarters of 2023, then in a rate-cutting cycle following the downward trend of the federal funds rate, it is obviously cheaper for short-term government bonds with positive term premiums. The Treasury Department also has the incentive to continue increasing the proportion of low-cost short-term debt issuance, while stabilizing the supply of medium- and long-term government bonds to prevent excessively high financing costs from exacerbating debt concerns and forming a negative cycle.

There is no need to overthink the third reason for the continuous rise in US Treasury yields.

In terms of demand, looking at the overall liquidity of banks, smaller banks are structurally safer: the percentage of cash at Silicon Valley Bank, which had issues in the crisis of small banks, was as low as below 5.5% before the crisis, and currently it is at 7.71% and in a slightly rising trend; large banks under stress tests do not have particularly high risks. The most direct way for the Fed to protect liquidity includes stopping balance sheet reduction and lowering interest rates, which was also the move the Fed took to stabilize the market during the repo crisis in 2019.

If the excessive supply of government bonds makes it difficult for interbank liquidity to absorb, then when inflation has already fallen below 3% and the size of the Federal Reserve's balance sheet has decreased from a peak of nearly $9 trillion to $7 trillion, it can stop quantitative tightening and provide emergency liquidity to banks through the discount window; the resulting economic concerns generally tend to further decrease long-term bond yields rather than sustain at high levels. If a large liquidity crisis erupts, the Federal Reserve also has the option to expand its balance sheet, but none of these actions can sustain long-term bond yields at high levels.

The fourth reason why there is no need to worry about the continuous rise in US bond yields

In the short term, the market seems to have already priced in the 'Trump trade' in anticipation of Trump's election and the subsequent rise in deficits and inflation. Even without considering the possibility of Harris winning the US election, Trump's current policy plans are still unclear. Policies like substantial tax cuts and universal tariff increases, which could significantly increase inflationary pressure, not only take time to be implemented but their actual impact is yet to be assessed. At the same time, Trump, once in office, will also need to control inflation. He has hinted that a looser monetary environment is required for the reshoring of US manufacturing, so it is not appropriate to equate Trump with higher long-term inflation and long-term US bond yields.

After the yield rises, the allocation value of long-term US bonds still remains

Overall, the central range for the 10-year US bond yield is still roughly around 3.7%-4.3%, with 4.3% already being the upper limit under a high evaluation of natural interest rates and term premiums. Although in the short term, under the conditions of economic data outperforming expectations, the Federal Reserve being more cautious in rate cuts, and the continued expansion of the fiscal deficit, there remains the possibility of a further increase in long-term US bond yields. However, the allocation value after exceeding 4.3% may once again become evident. In comparison, the performance of the US dollar index may be stronger, as in the short term, US economic growth appears significantly better than a basket of other countries in the US dollar index, and with other central banks expected to be more resolute in cutting rates, the time for the US dollar index to remain at high levels may be longer than that of US bond yields.

Risk warning: Risks of the US economy and labor market downturn, risks of unexpected liquidity issues in the US banking system, risks of misunderstanding statements by Federal Reserve officials.