Fed Hikes: What's Next for Treasury Yields?

The Federal Reserve hiked rates. What might be next?

The Fed raised its benchmark interest rate to the 3.75% to 4% range at its September Federal Open Market Committee (FOMC) meeting, its first hike since July 2023. Projections from Fed participants suggest that at least one more hike is likely, and we agree.

The "why" behind the hike is clear: inflation has held above the Fed's 2% target for over five years, and with a resilient economy and a stable labor market, an adjustment seemed necessary to bring inflation down to target in a timely manner.

Expectations for higher short-term interest rates have likely been a key driver behind the recent rise in long-term Treasury yields. Ironically, Fed rate hikes may prevent long-term yields from rising much further if they help keep inflation expectations in check.

Last month, we revised our expected range for the 10-year Treasury yield up to the 4.25% to 4.75% level. The direction was right, but not the level. With the 10-year Treasury yield now near 5%, it seems unlikely that the 10-year yield will be back to the 4.25% level over the short-run.

When the facts change, we change our view. As such, we think the 10-year Treasury yield will hold in the higher 4.5% to 5% range for now, but there could be some additional upside given the economic resilience. There may be periods where the yield could move above that range—much like it has lately.

What might this mean for investors?

• Fed rate hikes should pull up the yields on short-term investments. The yields on Treasury bills, short-term certificates of deposit, and money market funds have a strong relationship with the fed funds rate.
• Unless the economic growth outlook deteriorates, a hawkish Fed may put some sort of floor on long-term Treasury yields. That supports the increase in our expected 10-year Treasury yield range.
• Although long-term yields are at or near their 19-year highs, we don't think now is the time to tactically be adding long-term bonds just yet. As such, we suggest investors continue to favor a below-benchmark average duration.

Below we'll explain why we think additional hikes seem likely, what's been driving long-term yields higher, and why we still favor a below-benchmark average duration (meaning below the Bloomberg US Aggregate Index's average duration of six years).

The dot plot is where officials provide their assessment of the appropriate level of monetary policy at the end of the next few years. Fed Chair Kevin Warsh has made it clear he's not a fan of the dot plot and has not submitted his own projections. The rest of the committee submitted their projections, however, and the median dot projects one more hike by year-end, with an extended hold next year. The balance of risks is tilted toward more hikes, rather than fewer, as eight participants projected another hike by the end of 2027.

The fed funds futures market is pricing in a more hawkish path for monetary policy, with nearly three additional rate hikes by next June priced in. Market participants may have latched on to Warsh's comment that the rate hike removed "a dose of accommodation," tacitly acknowledging that monetary policy was accommodative to begin with. That suggests more work may need to be done.

We are more aligned with the median "dot" from the Fed, but we believe that the outlook is very uncertain. For the Fed to hike more than we expect, incoming inflation readings would likely need to come in on the strong side. Some key trends we'll be watching include:

• The monthly increases in core inflation. This is something New York Fed President John Williams has singled out, suggesting he'd need to see monthly readings of 0.2% or less to be confident that inflation is returning to the 2% target.
• The underlying breadth of price increases. Warsh has singled out the share of personal consumption expenditures (PCE) components rising above 3% on a year-over-year basis, which is shown in the chart below. If breadth improves while more headline-grabbing inflation indicators remain elevated, the Fed may be comfortable holding rates steady. If breadth doesn't improve, more hikes may come.
   

Short-term yields are likely to rise with additional rate hikes. The yields on short-term investments, like Treasury bills (shown below) and money market funds, tend to track the fed funds rate closely.

The relationship between the fed funds rate and the 10-year Treasury yields is less direct, however. The 10-year Treasury yield is forward looking and tends to move in advance of potential changes in the fed funds rate, as we'll discuss below.

Through September 17, the 10-year Treasury yield is up roughly 80 basis points, or 0.8%, this year, which has made many headlines and has likely made many investors anxious. We believe the move up is justified given the relatively strong economic fundamentals. The fed funds rate is likely at or below "neutral," the economy is growing, and the labor market is stable. A positively sloped yield curve—one where long-term yields are above short-term yields—makes sense in that environment.

The hawkish Fed and a higher expected short-term rate appear to be the key drivers of the move up this year. The chart below sums it up clearly: the expected fed funds rate for June 2027 is now more than 150 basis points higher than where the markets expected it to be at the end of 2025. Put that way, an 80-basis-point increase in the 10-year Treasury yield seems reasonable.

This chart below, courtesy of data from the Federal Reserve Bank of New York, helps explain that case as well. The Adrian, Crump, and Moench (ACM) model breaks down factors of the 10-year Treasury yield—it attributes the 10-year Treasury yield to the expected short-term interest rate and the "term premium." The term premium is defined as the compensation that investors require for bearing the risk that market interest rates may change over the life of the bond.

This chart highlights that most of the move up this year is due to the expected change in the short-term rate rather than the term premium. Unless the market begins to expect more rate hikes than the three the fed funds futures market currently implies, expected short-term yields might not pull long-term yields much higher.

The Fed's rate hike and overall hawkish bias may help keep long-term yields from rising significantly higher. A Fed that's committed to fighting inflation can keep inflation expectations anchored. More importantly, a Fed that follows through on its hawkish posture can also help boost its credibility.

We do see more risks to the upside than the downside. For yields to move materially lower, the economic outlook would likely need to deteriorate. And while there appears to be more upside potential than downside potential for the 10-year Treasury yield, our base case is for yields to hold in a range, and upside potential to be limited.

The relationship has changed over time, but historically, the 10-year Treasury yield tends to peak near the peak fed funds rate of a given cycle. That relationship broke down a bit during the last two cycles—it overshot the peak fed funds rate in 2018, then undershot it in 2023.

This may beg the question of why we're raising our expected trading range for the 10-year Treasury yield if the market is pricing in a fed funds futures rate of just 4.6% next year. With inflation still elevated, a resilient economy, and fiscal concerns potentially weighing on the bond market, the case can be made for the 10-year Treasury yield to hold a bit above that level for the time being. And historically, the 10-year Treasury yield tends to peak closer to the last rate hike of a given cycle, not the first.