The old New England expression "you can't get there from here" is said to come from locals trying to describe to newcomers the difficulty of navigating country roads blocked by the remnants of old stone fences. Today, it seems like a good analogy for the challenges facing investors hoping for a rally in the bond market. The prospect of interest rate cuts by the Federal Reserve would normally provide a clear path to lower bond yields. But the road to lower long-term yields isn't straight and faces a few obstacles.
With inflation elevated and fiscal deficits rising, there may not be much room for Treasury yields to fall much further, especially those with longer-term maturities. We look for a modest move down in short-to-intermediate term Treasury yields over the next few months as the Federal Reserve lowers the federal funds rate, but long-term yields are likely to remain elevated in the absence of falling inflation and/or a decline in fiscal deficits.
Inflation is stubborn
Recent inflation readings underscore the difficulty facing the bond market. Inflation has been above the Fed's 2% target for four years. It has fallen steeply from its pandemic peak but has been stuck in the 2.5% to 3.0% range for over a year. Recently, it has been edging higher and the flowthrough of tariffs will likely push it higher into 2026.
Inflation remains above the Fed's 2% target
Source: Bloomberg. Monthly data from 7/31/2015 to 7/31/2025.
PCE: Personal Consumption Expenditures Price Index (PCE DEFY Index), Core PCE: Personal Consumption Expenditures: All Items Less Food & Energy (PCE CYOY Index), percent change, year over year.
How much room is there for rate cuts?
The Fed's dual mandate requires it to set policy to achieve low inflation and full employment. With inflation elevated and the unemployment rate at 4.3%, it seems that a rate cut is not warranted. However, recent labor market data suggest there has been a slowdown in hiring with layoffs starting to pick up. The unemployment rate has held at a low level because there have been fewer new entrants into the labor force.
Fed Chair Jerome Powell and a handful of other voting members of the Federal Reserve's Federal Open Market Committee (FOMC) have indicated that they favor a rate cut at the September 16th-17th meeting to address the weakening trend. Reasoning that the current policy is "restrictive," they argue that a weaker labor market warrants a cut to a "neutral" policy stance. However, it's hard to define the current policy as restrictive when real gross domestic product (GDP) growth is rising at a year-over-year pace of about 2%, nominal GDP is running at a 4.5% pace, and financial markets are buoyant. It doesn't appear that the current level of interest rates is restricting lending or investing.
While we do expect some slowing in economic growth due to tariff impacts and cuts to some federal government programs and employment, two rate cuts are probably enough for now. More rate cuts might cause inflation to pick up—or at least inflation expectations.
Overall, we expect the Fed to cut rates at least twice by the end of the year, with the next cut likely coming at the September meeting. Beyond that, it would take a much weaker economy, a significant deterioration in the labor market, and/or much lower inflation to warrant further easing by the Fed.
How many cuts are enough?
The fed funds futures market is discounting a drop in the fed funds rate to less than 3% by the end of 2026. However, the "Taylor Rule"—a way to assess the policy rate while taking into account inflation and the unemployment rate—suggests that the current fed funds rate is at about the right level. It would require a significant drop in inflation and/or rise in the unemployment rate to conclude that the fed funds rate should drop sharply.
The "Taylor rule" suggests the federal funds rate is around the right level
Source: Federal Reserve Bank of Atlanta Taylor Rule Utility using data from 2/15/2012 to 8/15/2025.
Note: The Taylor rule is an equation John Taylor introduced in a 1993 paper that prescribes a value for the federal funds rate—the short-term interest rate managed by the FOMC—based on the values of inflation and economic slack such as the output gap or unemployment gap. Taylor Rule – Alternative 1 corresponds closely with the initial 1993 Taylor Rule, albeit with a different inflation measure and a time varying estimate of the natural interest rate instead of the 2% originally used by Taylor. Alternatives 2 and 3 use different calculations of the natural interest rate and the unemployment gap.
Fiscal policy is also a factor that could keep long-term bond yields from falling much. Rising deficits imply the need for higher debt issuance that will need to be absorbed by the market. In the U.S., the market has remained fairly sanguine on the prospect for ever-rising deficits, but the steepening of the yield curve is an indication of growing market concerns.
The difference in yields between five- and 30-year Treasuries, at 120 basis points, is the widest since 2021 as 30-year Treasury yields approached 5%. Our interpretation is that investors are demanding a higher yield for long-term Treasuries to compensate for the risk of inflation and/or depreciation of the dollar as a consequence of high debt levels.
The spread between the five- and 30-year Treasury yield is the widest since 2021
Bloomberg. Daily data from 9/3/2015 to 9/3/2025.
This spread is a calculated Bloomberg yield spread that replicates selling the current five-year U.S. Treasury Note and buying the current 30-year U.S. Treasury Note, then factoring the differences by 100. A basis point (bp or bps) is equal to 1/100th of 1%, or 0.01%. Past performance is no guarantee of future results.
Overall, we continue to expect yield-curve steepening will remain the dominant trend in the fixed income market for 2025 and likely into 2026. Investors should be aware of the differing time horizons when investing. We think the market may have gotten ahead of itself in discounting a series of rate cuts over the next year. The conditions appear right for a few rate cuts between now and year-end, but the pace and magnitude of easing in 2026 is still unclear. Currently, there are still some roadblocks to lower bond yields.
For investors, keeping average portfolio duration in the intermediate-term area of the yield curve still appears to be a reasonable way to earn interest income without taking too much interest rate risk. For those with a long-time horizon who are willing to ride out the ups and downs of the market, investing in bonds with maturities of 10 years and beyond can make sense when yields are high in both nominal and real terms. However, we would emphasize that there will likely be periods of volatility and that credit quality is especially important over a long time horizon.
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