US Treasury yields have retreated in line with expectations, and the 10-year Treasury rate surged then fell in the third quarter, with the 5.3% peak potentially marking the high for the year.
Since the release of the "Summer Cold Wind" series of reports on May 6, we have treated Treasury rates as a "gray rhino" worth watching, projecting that the 10-year Treasury rate could rise above 5% in the third quarter and reach around 5.3% in an extreme case. In the August 16 report "The Autumn Rally Will Shift from a Deep Rebound to Choppy Divergence Before Confirming a Reversal — Xiangjiang Strategy Data Weekly," we noted that the 10-year Treasury yield had broken through a near three-year high and could move toward 4.8%–4.9% in the coming weeks, or even touch around 5% in an extreme scenario. In the October 5 report "Fundamentals Are Key; Fish Where the Fish Are — Xiangjiang Strategy Data Weekly," we noted that the Treasury turmoil would see a turning point, and that the sharp September surge in the 10-year Treasury yield could not last. The 10-year Treasury yield recently rose to around 5.3%, fairly fully pricing in various macro fundamentals for this year. We maintain our earlier view that long-end Treasury rates are likely to pull back from highs in October.
Staged Moves in Treasury Yields: Logic and Market Validation
Phase One: Since May — Real Rates Dominate, the Curve Flattens and Rises
Logical judgment: Rigid upward moves in real rates, rising term premiums, and competition for capital from AI-related issuance.
In the August 10 report "The Root of Rising Treasury Yields: Rigid Strength in Real Rates; Earlier Hikes May Be the Way Out," we noted that the core driver pushing long-end Treasury rates higher is the rigid rise in real rates. Although inflation expectations remain relatively mild, the unexpectedly resilient US real economy, a steady labor market, and strong services consumption support expectations of high returns on real capital investment and risk premiums, thereby supporting a continued rise in the 10-year Treasury real rate. In addition, expanding public debt and rising long-term Treasury supply pressure, combined with concerns over policy independence, have raised investors' required risk compensation for long duration. Since 2022, the sharp rise in government bond issuance has also competed for capital with AI-related issuance. After the late-July FOMC meeting, Waller's strategic simplicity sparked market divergence, and long-end Treasury yields continued to climb. The July nonfarm payrolls released on August 7 fell by 23,000 (along with downward revisions to prior months), directly causing the probability of a September hike to fall sharply from about 55%–57% to around 40%. Subsequently, an unexpected contraction in July retail sales, declining consumer confidence, and relatively mild July inflation data further reinforced the market's judgment that the Fed would hold steady. By mid-August, the probability of a September hike had once fallen to about 25%–30%. However, we argued that even if inflation trends lower, that does not mean the Fed cannot hike. Inflation is not a hard constraint on current rate hikes. We believe an earlier hike may be an important option for the Fed's monetary policy adjustment and can achieve multiple goals at once: on one hand, an earlier hike (for example, in September) can break the path dependence of the central bank yielding to capital markets, rebuild the Fed's credibility, and signal to the market a firm stance against inflation; on the other hand, actively pushing up nominal rates and influencing real rates aims to release risks in a concentrated way through a short-term spike in rates. In the August 31 report "Waller's 'Changes and Constants' — Jackson Hole Global Central Bank Symposium Review," we noted that short-term market uncertainty is relatively high, but regardless of the choice, long-end Treasury rates are likely to first rise and then fall in the second half of the year, with relief coming after the worst.
Phase Two: September 23 to October 14 — Long-End Treasury Rates Spike, the Curve Shifts from Bear Flattening to Bear Steepening
Logical judgment: Falling rate-hike expectations, shrinking risk budgets in a high-volatility environment, and short-term trading factors amplified the rise in long-end yields.
The main contradiction in the rise of long-end Treasury rates shifted from the level of rates to the speed of the rise. Reasons for the spike in long-end Treasury rates: 1) Downward revisions to employment data plus slower PCE growth reduced market expectations for a hike, and the 2-year yield fell; the 10-year and 30-year yields continued to rise, and the curve shifted from bear flattening to bear steepening. 2) Shrinking risk budgets in a high-volatility environment, combined with reduced market depth and weaker absorption capacity at quarter-end, amplified the rise in long-end yields. However, we judged that an overly fast spike in Treasury rates would be hard to sustain, and short-term attention should focus on a phase of repair: 1) Policy and fundamental conditions began to turn. Weakening employment and widening credit spreads are raising the probability of downward revisions to policy expectations. 2) Short-term trading factors may fade, and high yields are beginning to attract allocation demand. 3) The overseas bond market turmoil has not yet evolved into a global financial crisis. In the October 5 report "US September Nonfarm Payrolls Review: Cooling Employment, the Fed's Restrictive Policy Effects Begin to Appear," we noted that the restrictive stance of Fed monetary policy has begun to show effects. Moreover, the speed of this round of long-end rate increases is relatively rare; since the September FOMC rate hike, the rise in long-end yields has been very fast by historical standards in Fed hiking cycles. Its trajectory can be compared with gold in January this year, oil prices in the initial phase of the Middle East conflict in March, and AI hardware such as storage and optical modules in June, which often cannot be sustained. Therefore, we judged that the direction of rate increases may not be wrong, but the short-term speed is clearly too fast, and historical patterns suggest there is room for some pullback and repair. Overall, the 10-year Treasury yield above 5.3% already offers some allocation value.
Phase Three (Market Validation): After October 14 — Long-End Treasury Rates Spike (5.36%) and Pull Back, Potentially Peaking for the Year
Logical judgment: After the data details are digested, the Fed's pace and path of rate hikes become clearer, real rates dominate, and high yield levels drive demand for fund reallocation.
1) After the September CPI beat expectations, the 10-year Treasury yield spiked and then fell, and the short-term downward trend remains intact. Overall CPI was largely driven by energy prices such as gasoline; although the core reading was firm, it was not comprehensively out of control, mainly supported by large and persistent components such as housing. 2) Recent Fed officials' comments emphasized that there is time to observe and no need to act urgently in October. The probability of an October hike fell from a peak of about 50%, and upward pressure on long-end rates weakened accordingly. 3) Inflation expectations are stable, and the rise in Treasury yields is mainly driven by real rates. This also shows that the Fed has rebuilt credibility in fighting inflation, so long-term inflation expectations will not spiral out of control. Rate levels are matching fundamentals. 4) The yield level itself already offers allocation value. The 2-year Treasury yield near 5% is a rare level in nearly 20 years, and demand for fund reallocation is pushing ETF and mutual fund flows into the bond market. Allocation demand provided buying support after Treasury yields spiked, limiting further increases and driving them lower.
Looking Ahead: Short Term, the October FOMC May Deliver a Hawkish Pause; Medium to Long Term, Long-End Treasury Rates Will Match Fundamentals
Waller's latest remarks: Compared with the previous Jackson Hole appearance, Waller's stance is more neutral while continuing his long-standing positions, such as: not prejudging future meetings; inflation is a global issue; the resilience of the US economy; the short-term and medium- to long-term effects of AI; and not prejudging the conclusions of the Fed's working group. Waller specifically noted that the Fed raised rates at the September meeting, taking back some monetary easing, and that since the last hike, the global economy has broadly moved in line with the Fed's expectations. In addition, Waller spent considerable space discussing AI's impact on the economy: AI pushes up investment demand and inflation in the short term, and raises productivity and may lower inflation in the long term. This positively affirms AI and the investment demand it brings. Therefore, regarding inflation caused by AI, at least in the short term, he expressed a degree of openness or even tolerance. In the short term, hot data and standing pat in October are not contradictory: after the Fed raised rates by 25bps at the September FOMC meeting, we expect the Fed may choose to hold steady in October to give relatively high Treasury yields more time to tighten financial conditions, while preserving policy flexibility and an observation window and shifting the real policy decision point to the December meeting. In the medium to long term, long-end Treasury rates will match fundamentals: 1) In terms of US economic fundamentals, AI investment and consumption remain the main supports, and domestic demand is generally strong. If AI investment growth continues to raise potential growth and the equilibrium real rate in the coming quarters, the corresponding long-end rate level will also be higher; conversely, if AI investment growth later falls more than expected, then the early-October high in long-end Treasury rates may be the major peak of this AI cycle. In addition, short-term inflation stickiness remains. September CPI and PPI show that upstream cost pressures have not risen overall, but downstream services—especially housing and transportation services—show "last mile" stickiness, indicating that upstream supply-side shocks are being transmitted down the industrial chain. In the long term, however, the rapid spread of AI applications may systematically lower the inflation center. 2) In terms of Treasury supply and demand, over the medium term, the resilience of the US economy and historically relatively high yield levels enhance the allocation appeal of Treasuries. In the short term, long-duration issuance by AI companies and fiscal issuance coexist, constraining room for term premiums to fall.
This report's analysts: Zhang Yidong, SFC HK license number: BIS749; Liu Nianyun, SFC HK license number: BXH708.
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