The Federal Reserve's decision to hold interest rates steady this week continues to unsettle the bond market. Long-dated Treasury yields remain elevated after the latest economic data release, with inflation and labor market resilience deepening divisions on the future rate path. The steepening yield curve is driving a shift toward risk-off sentiment.
The 30-year Treasury yield surged over 10 basis points on Wednesday to its highest level since 2007, hovering around 5.20% on Thursday.
The US June PCE price index fell 0.1% month-over-month, the first monthly decline since 2020, while the annual rate narrowed to 3.7% from 4.1% in the prior month. Core PCE, excluding energy, eased slightly to 3.3% year-over-year from 3.4%, with a monthly increase of just 0.1%, below the market consensus of 0.2%.
Meanwhile, oil prices, which had dipped in June, rebounded after the US resumed military operations against Iran, heightening concerns over Middle East supply risks.
Interest rate swap markets indicate about a two-thirds probability of a 25-basis-point rate hike by the Fed in September, down from being fully priced in before the Fed's decision.
Long-end yields stay high, inflation expectations jump
After the Fed's pause, long-end Treasury yields have struggled to retreat, supported by persistent concerns over inflation durability.
The 30-year breakeven inflation rate—a key measure of market inflation expectations—surged 6 basis points on Wednesday, marking the largest single-day jump since the day after Donald Trump's presidential election win in November 2024.
Oil's renewed climb following the US military strike on Iran has further reinforced inflation expectations amid uncertainty over Middle East supply.
Jens Peter Sorensen, chief analyst at Danske Bank A/S, commented: "If inflation fails to slow, long-end bond yields face further upside risks. Markets can only guess how many more rate hikes are needed, and the timing may be later than expected."
Short-end yields fall, curve steepening trend continues
In contrast, short-term Treasury yields continued to decline on Thursday, with the 2-year to 5-year yields each dropping about 5 basis points to weekly lows.
This move was partly driven by UK markets—after the Bank of England's policy meeting, gilt traders scaled back bets on a September rate hike, dragging down UK gilt yields. The yen's single-day gain of over 3% against the dollar also supported short-end Treasury yields.
As a result, key term spreads widened further, returning to levels seen since May: the 2-year vs 10-year yield spread approached 45 basis points, while the 5-year vs 30-year spread expanded to 84 basis points, with the yield curve continuing to steepen.
Big money bets on higher long-end yields in options market
The steepening trend has spurred significant hedging demand in derivatives, with investors turning to Treasury options to protect against further rises in long-end yields.
On Thursday, a $13 million options trade emerged, betting that the 10-year Treasury yield would rise to 4.80% within weeks—matching last year's highs.
On Wednesday, a massive September options trade on Treasury futures targeted the 30-year yield rising to around 5.3% within weeks. Both options expire on August 21.
Fed credibility questioned, rate path uncertain
The Fed's decision to hold rates steady under Chair Kevin Warsh has sparked doubts about its commitment to fighting inflation, raising uncertainty over the rate path.
Torsten Slok, chief economist at Apollo Global Management, said in an interview: "We need to discuss the committee's credibility issue. It can't just be rhetoric—it must eventually be backed by action."
Earlier, markets had priced in about a 40% chance of a rate hike at this meeting to signal Warsh's anti-inflation stance, but that expectation failed to materialize. Swap markets now indicate a lower probability of a September hike, while the chance of a second rate hike this year has halved to around 40% from roughly 80% earlier.
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